Rare Disasters and Risk Sharing with Heterogeneous Beliefs
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Chen_Rare disasters.pdf
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637.05 KB
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Author(s)
Chen, Hui
Joslin, Scott Stephen Walter
Tran, Ngoc-Khanh
Date Issued
June 2012
Journal
Review of Financial Studies
Publisher
Oxford University Press
Citation
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.
Version
Author's final manuscript
Abstract
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.
MIT Department
Sloan School of Management
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Creative Commons Attribution-Noncommercial-Share Alike 3.0
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DOI of Published Version
https://doi.org/10.1093/rfs/hhs064
