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Rare Disasters and Risk Sharing with Heterogeneous Beliefs (2012)
| Citations: | 15 - 1 self |
BibTeX
@MISC{Chen12raredisasters,
author = {Hui Chen and Scott Joslin and Ngoc-khanh Tran and Presented Scott Joslin},
title = {Rare Disasters and Risk Sharing with Heterogeneous Beliefs},
year = {2012}
}
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Abstract
Although the threat of rare economic disasters can have large effect on asset prices, difficulty in inference regarding both their likelihood and severity provides the potential for disagreements among investors. Such disagreements lead investors to insure each other against the types of disasters each one fears the most. Due to the highly nonlinear relationship between consumption losses in a disaster and the risk premium, a small amount of risk sharing can significantly attenuate the effect that disaster risk has on the equity premium. The model has several predictions. First, it shows that time variation in the wealth distribution and the amount of disagreement across agents can significantly amplify the variation in disaster risk premium. Second, it provides caution to the approach of extracting disaster probabilities from asset prices, which can disproportionately reflect the beliefs of a small group of optimists and can either exaggerate or understate the variations in disaster probabilities over time. Third, the model predicts an inverse U-shaped relationship between the equity premium and the size of the disaster insurance market.
Keyphrases
risk sharing rare disaster heterogeneous belief disaster probability equity premium asset price several prediction disaster insurance market consumption loss wealth distribution nonlinear relationship risk premium small amount large effect disaster risk time variation disaster risk premium rare economic disaster inverse u-shaped relationship small group
