49 Pages Posted: 18 Mar 2010 Last revised: 2 Sep 2013
Date Written: October 18, 2011
Risks of rare economic disasters can have large impact on asset prices. At the same time, difficulty in inference regarding both the likelihood and severity of disasters as well as agency problems can effectively lead to signiffcant disagreements among investors about disaster risk. We show that such disagreements generate strong risk sharing motives, such that just a small amount of optimists in the economy can 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 can increase dramatically when the risk sharing capacity of the optimists is reduced, for example, following a disaster. The model also helps reconcile the difference in the amount of disaster risk implied by nancial markets and international macro data, and provides caution to the approach of extracting disaster probabilities from asset prices, which can 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.
Suggested Citation: Suggested Citation
Chen, Hui and Joslin, Scott and Tran, Ngoc-Khanh, Rare Disasters and Risk Sharing with Heterogeneous Beliefs (October 18, 2011). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1572665 or http://dx.doi.org/10.2139/ssrn.1572665