Hills Sustainability
10 May 2024 Financial Analysts Journal Volume 80, Issue 3

Factor-Mimicking Portfolios for Climate Risk

  1. Gianluca De Nard
  2. Robert F. Engle
  3. Bryan Kelly
The authors present a method for optimally hedging climate risk that incorporates new methodologies for estimating large-dimensional covariance matrices in short samples. The enhanced method is shown to be more efficient than traditional approaches.
Read the Complete Article in the Financial Analysts Journal CFA Institute Member Content


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.

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