Abstract
We employ a varDelta CoVaR model in order to measure the potential impact of temperature fluctuations on systemic risk, considering all companies from the STOXX Europe 600 Index, which covers a wide range of industries for the period from 1/1/1990 to 29/12/2017. Furthermore, in this study, we decompose temperature into 3 factors; namely (1) trend, (2) seasonality and (3) anomaly. Findings suggest that, temperature has indeed a significant impact on systemic risk. In fact, we provide significant evidence of either positive or nonlinear temperature effects on financial markets, while the nonlinear relationship between temperature and systemic risk follows an inverted U-shaped curve. In addition, hot temperature shocks strongly increase systemic risk, while we do witness the opposite for cold shocks. Additional analysis shows that deviations of temperature by 1,^{circ }hbox {C} can increase the daily Value at Risk by up to 0.24 basis points. Overall, higher temperatures are highly detrimental for the financial system. Results remain robust under the different proxies that were employed to capture systemic risk or temperature.
Highlights
Understanding the empirical relationship between climate change and financial markets is gaining much prominence within the recent climate - finance literature
The economic interpretation of Conditional Value at Risk (CoVaR) is similar to the interpretation of the correlation coefficients (Adrian and Brunnermeier 2016)
Most of the control variables appear significant, with the January dummy, market return and market capitalization being the ones decreasing systemic risk, while precipitation, Monday dummy, TED, credit risk, volatility and yield are associated with higher CoVaR
Summary
Understanding the empirical relationship between climate change and financial markets is gaining much prominence within the recent climate - finance literature. The persistent trend of rising temperature has been spreading uncertainty to the whole financial system and it significantly contributes to systemic risk (e.g., Battiston et al 2017). Variations of temperature can trigger a direct revaluation of climate sensitive assets. Firms that possess climate sensitive assets could affect the financial system given their high interconnection with other businesses, thereby increasing systemic risk indirectly (Battiston et al 2017). What can be observed, historically, is investors’ reaction on temperature changes. With these in mind, our overriding priority is to investigate whether systemic risk is conditioned on temperature changes.
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