Options on Interbank Rates and Implied Disaster Risk

Abstract

The identification of disaster risk has remained a significant challenge due to the rarity of macroeconomic disasters. We show that the interbank market can help characterize the time variation in disaster risk. We propose a risk-based model in which macroeconomic disasters are likely to coincide with interbank market failure. Using interbank rates and their options, we estimate our model via MLE and filter out the short-run and long-run components of disaster risk. Our estimation results are independent of the stock market and serve as an external validity test of rare disaster models, which are typically calibrated to match stock moments.

Keywords: economic disasters, time-varying disaster risk, interbank rates, interbank rate options, maximum likelihood estimation, extended Kalman filter

JEL Classification: G12, G13, C13, C58