22. May 2024
5 minutes

Measuring and hedging climate risks

Another OLZ publication in a renowned journal

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Our Head of Quantitative Research Dr. Gianluca De Nard publishes his latest research together with Nobel Prize winner Prof. Robert F. Engle (New York University) and Prof. Bryan Kelly (Yale University and AQR Capital Management) on measuring and hedging climate risks in portfolio optimization in the renowned Financial Analyst Journal of the CFA Institute.

Factor-Mimicking Portfolios for Climate Risk

This international and interdisciplinary research study examines how various climate risks can be measured and "hedged" on the financial markets. First, various well-known journals are analyzed using the latest algorithms in order to publish various climate risk indices in real time:

In a second step, these indices are then replicated on the financial markets using the latest statistical methods in order to hedge climate risks as well as possible with efficient and sustainable portfolios.

Initial situation

In recent years, climate change has left deep marks on our world as a growing phenomenon. It is no longer just an environmental problem, but poses a serious threat to the stability of the global economy. Extreme weather events such as uncontrollable forest fires and rising sea levels cause not only ecological but also considerable financial damage. It is becoming increasingly important for investors and companies to integrate these climate risks into their financial strategies in order to reduce unforeseeable losses.

Measuring climate risks

Faced with these challenges, the financial industry has begun to rethink traditional approaches and develop new, more dynamic strategies. One revolutionary approach, presented in a recent study by Gianluca De Nard, Robert F. Engle and Bryan Kelly, uses so-called "factor-tracking portfolios". These are based on real-time indices derived from a broad text analysis of current news to reflect rapidly changing climate risks. These indices serve as a compass for investors to steer more safely through the stormy waters of climate-related financial risks. They not only capture the current mood in the climate debate, but also provide an immediate assessment of climate risks. These can be of a physical nature or arise from the transition to a more sustainable economy.

Replication and reduction of climate risks on the financial markets

The innovative method of integrating climate risks into portfolio optimization and improved estimation of large covariance matrices in short samples allow these portfolios to not only stand up to theoretical scrutiny, but also offer significant financial benefits in practice. The portfolios have shown that they can achieve high alphas and significant betas that are directly correlated with climate risk indices.

The study has direct implications for investors. Not only does it provide a concrete tool for integrating climate considerations into portfolio management, but it also promotes a link between financial prudence and sustainable practice. These portfolios are not only a better hedge against climate risks, but also a sign of a responsible and future-oriented investment strategy.

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