The (Time-Varying) Importance of Disaster Risk

32 Pages Posted: 22 Apr 2015 Last revised: 18 Feb 2016

See all articles by Ivo Welch

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: February 9, 2016

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

Suggested Citation

Welch, Ivo, The (Time-Varying) Importance of Disaster Risk (February 9, 2016). Financial Analysts Journal, Forthcoming July/August 2016, Available at SSRN: https://ssrn.com/abstract=2596909 or http://dx.doi.org/10.2139/ssrn.2596909

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