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Factor-Mimicking Portfolios for Climate Risk

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  • Gianluca De Nard
  • Robert F. Engle
  • Bryan Kelly

Abstract

We propose and implement a procedure to optimally hedge climate change risk. First, we construct climate risk indices through textual analysis of newspapers. Second, we present a new approach to compute factor-mimicking portfolios to build climate risk hedge portfolios. The new mimicking portfolio approach is much more efficient than traditional sorting or maximum correlation approaches by taking into account new methodologies of estimating large-dimensional covariance matrices in short samples. In an extensive empirical out-of-sample performance test, we demonstrate the superior all-around performance delivering markedly higher and statistically significant alphas and betas with the climate risk indices.

Suggested Citation

  • Gianluca De Nard & Robert F. Engle & Bryan Kelly, 2024. "Factor-Mimicking Portfolios for Climate Risk," Financial Analysts Journal, Taylor & Francis Journals, vol. 80(3), pages 37-58, July.
    • Handle: RePEc:taf:ufajxx:v:80:y:2024:i:3:p:37-58
    DOI: 10.1080/0015198X.2024.2332164
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    More about this item

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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