Francisco Perez-Gonzalez
Stanford University; National Bureau of Economic Research (NBER)

Hayong Yun
University of Notre Dame

Abstract

This paper examines the impact of financial innovation on firm value, investment, and financing decisions. More specifically, we examine the effect of the introduction of weather derivatives on electric and gas utilities, arguably some of the most weather-exposed businesses in the economy. Weather derivatives were introduced in 1997 to help firms manage their weather-related risk exposure. We derive instruments for weather derivative use based on historical (pre-1997) weather exposure. Intuitively, firms whose cash flows have historically fluctuated with changing weather conditions are, relative to other firms, more likely to use weather derivatives once they become available, irrespective of their investment opportunities. Using data from U.S. energy firms, we find that weather derivatives lead to higher market valuations, investments, and leverage. Overall, our results demonstrate that financial innovation can significantly affect firm outcomes and that risk management meaningfully affects valuation, investments, and financing decisions.

This is an early version of a paper which is forthcoming in the Journal of Finance.

Further information here