Heterogeneous Beliefs, Rare Disasters, and Asset Pricing
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Chen_Heterogeneous Beliefs.pdf
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Author(s)
Chen, Hui
Joslin, Scott Stephen Walter
Tran, Ngoc-Khanh
Date Issued
January 2010
Journal
Papers of the Allied Social Science Associations
Publisher
American Economic Association
Citation
Chen, Hui, Scott Joslin and Ngoc-Khanh Tran. "Heterogeneous Beliefs, Rare Disasters, and Asset Pricing." in Papers of the Allied Social Science Associations, AEA Annual Meeting, January 2-5, 2010, Atlanta Marriott Marquis, Atlanta, GA,
Version
Final published version
Abstract
We illustrate the effects of heterogeneous beliefs about disasters on the equity premium
and individual agents’ trading activities. When investors disagree about the chances or
severity of disasters, those optimistic investors may insure the pessimists against their
disaster risk exposure. Due to the highly non-linear relationship between the consumption
losses during a disaster and the risk premium, a small amount of risk sharing can
significantly attenuate the effect that disasters have on the equity premium. Thus, the
equity premium will remain low even when the economy is predominantly occupied by
pessimistic investors, but jump up following a disaster. The effects of risk sharing become
stronger when the differences in beliefs are large, or when the optimistic agents
also have lower risk aversion. Other interesting predictions of the model include a nonmonotonic relationship between the equity premium and the size of the disaster insurance
market, as well as a negative relationship between the equity premium and the amount
of disagreements about disasters.
MIT Department
Sloan School of Management
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www.aeaweb.org/aea/conference/program/retrieve.php?pdfid=494
