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The Probability of Rare Disasters: Estimation and Implications

82 Pages Posted: 25 Mar 2015 Last revised: 10 Nov 2015

Emil Siriwardane

Harvard Business School - Finance Unit; Office of Financial Research

Date Written: October 30, 2015

Abstract

I analyze a rare disasters economy that yields a measure of the risk neutral probability of a macroeconomic disaster, p*t . A large panel of options data provides strong evidence that p*t is the single factor driving option-implied jump risk measures in the cross section of firms. This is a core assumption of the rare disasters paradigm. A number of empirical patterns further support the interpretation of p*t as the risk-neutral likelihood of a disaster. First, standard forecasting regressions reveal that increases in p*t lead to economic downturns. Second, disaster risk is priced in the cross section of U.S. equity returns. A zero-cost equity portfolio with exposure to disasters earns risk-adjusted returns of 7.6% per year. Finally, a calibrated version of the model reasonably matches the: (i) sensitivity of the aggregate stock market to changes in the likelihood of a disaster and (ii) loss rates of disaster risky stocks during the 2008 financial crisis.

Keywords: disaster risk, rare events, option pricing, pricing of disaster risk

Suggested Citation

Siriwardane, Emil, The Probability of Rare Disasters: Estimation and Implications (October 30, 2015). Harvard Business School Finance Working Paper No. 16-061. Available at SSRN: https://ssrn.com/abstract=2584047 or http://dx.doi.org/10.2139/ssrn.2584047

Emil Siriwardane (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States

Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

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