Rare Event Risk and Heterogeneous Beliefs: The Case of Incomplete Markets

Abstract

This paper provides an equilibrium model subject to heterogeneous beliefs about the likelihood of rare events. I explore asset pricing implications in an incomplete capital market and the effects of market completion. Without explicit rare event insurance, investors insure themselves indirectly through the stock and money markets, the risk premium is countercyclical, and flight to quality effects arise. Upon market completion, the risk premium increases as investors increase their exposure to rare event risk. While market completion leads to a more efficient allocation based on investors' anticipatory utilities, its effect on ex-post efficiency is ambiguous.

Keywords: Rare Event Risk, Heterogeneous Beliefs, Incomplete Markets, Catastrophe Insurance, Exchange Economy

JEL Classification: D51, D52, G11, G12, G13