Heterogeneous Beliefs, Rare Disasters, and Asset Pricing

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.