Rare Disasters and Risk Sharing with Heterogeneous Beliefs
Risks of rare economic disasters can have a large impact on asset prices. At the same time, difficulties in inference regarding both the likelihood and severity of disasters, as well as agency problems, can lead to significant disagreements among investors about disaster risk. We show that such disa...
| Main Authors: | , , |
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| Other Authors: | |
| Format: | Article |
| Language: | en_US |
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Oxford University Press
2012
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| Online Access: | http://hdl.handle.net/1721.1/74652 https://orcid.org/0000-0001-9605-641X |
| _version_ | 1811076707131588608 |
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| author | Chen, Hui Joslin, Scott Stephen Walter Tran, Ngoc-Khanh |
| author2 | Sloan School of Management |
| author_facet | Sloan School of Management Chen, Hui Joslin, Scott Stephen Walter Tran, Ngoc-Khanh |
| author_sort | Chen, Hui |
| collection | MIT |
| description | Risks of rare economic disasters can have a large impact on asset prices. At the same time, difficulties in inference regarding both the likelihood and severity of disasters, as well as agency problems, can lead to significant disagreements among investors about disaster risk. We show that such disagreements generate strong risk-sharing motives, such that just a small number of optimists in the economy will significantly reduce the disaster risk premium. Our model highlights the “latent” nature of disaster risk. The disaster risk premium will likely be low and smooth during normal times but increases dramatically when the risk-sharing capacity of the optimists is reduced, e.g., following a disaster. The model also helps reconcile the difference in the amount of disaster risk implied by financial markets and international macroeconomic data, and provides caution to the approach of extracting disaster probabilities from asset prices, which will disproportionately reflect the beliefs of a small group of optimists. Finally, our model predicts an inverse U-shaped relation between the equity premium and the size of the disaster insurance market. |
| first_indexed | 2024-09-23T10:26:17Z |
| format | Article |
| id | mit-1721.1/74652 |
| institution | Massachusetts Institute of Technology |
| language | en_US |
| last_indexed | 2024-09-23T10:26:17Z |
| publishDate | 2012 |
| publisher | Oxford University Press |
| record_format | dspace |
| spelling | mit-1721.1/746522022-09-26T17:54:16Z Rare Disasters and Risk Sharing with Heterogeneous Beliefs Chen, Hui Joslin, Scott Stephen Walter Tran, Ngoc-Khanh Sloan School of Management Chen, Hui Tran, Ngoc-Khanh Joslin, Scott Stephen Walter Risks of rare economic disasters can have a large impact on asset prices. At the same time, difficulties in inference regarding both the likelihood and severity of disasters, as well as agency problems, can lead to significant disagreements among investors about disaster risk. We show that such disagreements generate strong risk-sharing motives, such that just a small number of optimists in the economy will significantly reduce the disaster risk premium. Our model highlights the “latent” nature of disaster risk. The disaster risk premium will likely be low and smooth during normal times but increases dramatically when the risk-sharing capacity of the optimists is reduced, e.g., following a disaster. The model also helps reconcile the difference in the amount of disaster risk implied by financial markets and international macroeconomic data, and provides caution to the approach of extracting disaster probabilities from asset prices, which will disproportionately reflect the beliefs of a small group of optimists. Finally, our model predicts an inverse U-shaped relation between the equity premium and the size of the disaster insurance market. 2012-11-15T18:33:31Z 2012-11-15T18:33:31Z 2012-06 Article http://purl.org/eprint/type/JournalArticle 0893-9454 1465-7368 http://hdl.handle.net/1721.1/74652 Chen, H., S. Joslin, and N.-K. Tran. “Rare Disasters and Risk Sharing with Heterogeneous Beliefs.” Review of Financial Studies 25.7 (2012): 2189–2224. https://orcid.org/0000-0001-9605-641X en_US http://dx.doi.org/ 10.1093/rfs/hhs064 Review of Financial Studies Creative Commons Attribution-Noncommercial-Share Alike 3.0 http://creativecommons.org/licenses/by-nc-sa/3.0/ application/pdf Oxford University Press SSRN |
| spellingShingle | Chen, Hui Joslin, Scott Stephen Walter Tran, Ngoc-Khanh Rare Disasters and Risk Sharing with Heterogeneous Beliefs |
| title | Rare Disasters and Risk Sharing with Heterogeneous Beliefs |
| title_full | Rare Disasters and Risk Sharing with Heterogeneous Beliefs |
| title_fullStr | Rare Disasters and Risk Sharing with Heterogeneous Beliefs |
| title_full_unstemmed | Rare Disasters and Risk Sharing with Heterogeneous Beliefs |
| title_short | Rare Disasters and Risk Sharing with Heterogeneous Beliefs |
| title_sort | rare disasters and risk sharing with heterogeneous beliefs |
| url | http://hdl.handle.net/1721.1/74652 https://orcid.org/0000-0001-9605-641X |
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