Rare Event Risk and Heterogeneous Beliefs: The Case of Incomplete Markets
University of Pennsylvania - Finance Department
November 5, 2009
Journal of Financial and Quantitative Analysis (JFQA), Forthcoming
This paper provides an equilibrium model subject to heterogeneous beliefs about the likelihood of rare events. I explore asset pricing implications in an incomplete capital market and the effects of market completion. Without explicit rare event insurance, investors insure themselves indirectly through the stock and money markets, the risk premium is countercyclical, and flight to quality effects arise. Upon market completion, the risk premium increases as investors increase their exposure to rare event risk. While market completion leads to a more efficient allocation based on investors' anticipatory utilities, its effect on ex-post efficiency is ambiguous.
Number of Pages in PDF File: 46
Keywords: Rare Event Risk, Heterogeneous Beliefs, Incomplete Markets, Catastrophe Insurance, Exchange Economy
JEL Classification: D51, D52, G11, G12, G13Accepted Paper Series
Date posted: January 10, 2005 ; Last revised: April 8, 2011
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