Living with Ambiguity: Pricing Mortality‐Linked Securities with Smooth Ambiguity Preferences

28 Pages Posted: 30 Aug 2013

See all articles by Hua Chen

Hua Chen

Temple University - Risk Management & Insurance & Actuarial Science

Michael Sherris

University of New South Wales - ARC Centre of Excellence in Population Ageing Research and School of Risk and Actuarial Studies; UNSW Australia Business School

Tao Sun

Independent

Wenge Zhu

Shanghai University of Finance and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: September 2013

Abstract

Mortality is a stochastic process. We have imprecise knowledge about the probability distribution of mortality rates in the future. Mortality risk, therefore, can be defined in a broader term of ambiguity. In this article, we investigate the effects of ambiguity and ambiguity aversion on prices of mortality‐linked securities. Ambiguity may arise from parameter uncertainty due to a finite sample of data and inaccurate old‐age mortality rates. We compare the price of a mortality bond in three scenarios: (1) no parameter uncertainty, (2) parameter uncertainty with Bayesian updates, and (3) parameter uncertainty with the smooth ambiguity preference. We use the indifference pricing approach to derive the minimum ask price and the maximum bid price, and adopt the economic pricing method to compute the equilibrium price that clears the market. We reveal the connection between the indifference pricing approach and the economic pricing approach and find that ambiguity aversion has a much smaller effect on prices of mortality‐linked securities than risk aversion in our example.

Suggested Citation

Chen, Hua and Sherris, Michael and Sun, Tao and Zhu, Wenge, Living with Ambiguity: Pricing Mortality‐Linked Securities with Smooth Ambiguity Preferences (September 2013). Journal of Risk and Insurance, Vol. 80, Issue 3, pp. 705-732, 2013. Available at SSRN: https://ssrn.com/abstract=2318235 or http://dx.doi.org/10.1111/j.1539-6975.2013.12001.x

Hua Chen (Contact Author)

Temple University - Risk Management & Insurance & Actuarial Science ( email )

Fox School of Business and Management
1801 Liacouras Walk, 625 Alter Hall
Philadelphia, PA 19122
United States
(215) 204-5905 (Phone)
(215) 204-4712 (Fax)

Michael Sherris

University of New South Wales - ARC Centre of Excellence in Population Ageing Research and School of Risk and Actuarial Studies ( email )

Australian School of Business
Quadrangle Building
Sydney, NSW 2052
Australia
+61 2 9385 2333 (Phone)
+61 2 9385 1883 (Fax)

HOME PAGE: http://www.asb.unsw.edu.au/schools/Pages/MichaelSherris.aspx

UNSW Australia Business School ( email )

Sydney, NSW 2052
Australia

Tao Sun

Independent

No Address Available

Wenge Zhu

Shanghai University of Finance and Economics ( email )

AK Shanghai

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