The (Time-Varying) Importance of Disaster Risk

Abstract

How much of the historical 7%/year equity premium could have been risk compensation for disasters that just happened not to have occurred? The answer can be found in below-the-money put prices which would have protected against them. A premium beyond 2%/year (for rolling one-month-ahead disasters) would have meant that index put options would have been too cheap. Thus, at least 5%/year remains to be explained by reasons other than sudden disasters. My paper also provides a novel “conservative diffuse prior” approach for dealing with black-swan risk.

Keywords: black swans, disasters, catastrophes, dark events, equity premium