Rare Disasters and Risk Sharing with Heterogeneous Beliefs

Hui Chen (), Scott Joslin and Ngoc-Khanh Tran

The Review of Financial Studies, 2012, vol. 25, issue 7, 2189-2224

Abstract: Risks of rare economic disasters can have a large impact on asset prices. At the same time, difficulties in inference regarding both the likelihood and severity of disasters, as well as agency problems, can lead to significant disagreements among investors about disaster risk. We show that such disagreements generate strong risk-sharing motives, such that just a small number of optimists in the economy will significantly reduce the disaster risk premium. Our model highlights the "latent" nature of disaster risk. The disaster risk premium will likely be low and smooth during normal times but increases dramatically when the risk-sharing capacity of the optimists is reduced, e.g., following a disaster. The model also helps reconcile the difference in the amount of disaster risk implied by financial markets and international macroeconomic data, and provides caution to the approach of extracting disaster probabilities from asset prices, which will disproportionately reflect the beliefs of a small group of optimists. Finally, our model predicts an inverse U-shaped relation between the equity premium and the size of the disaster insurance market. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Date: 2012
References: Add references at CitEc
Citations: View citations in EconPapers (60)

Downloads: (external link)
http://hdl.handle.net/10.1093/rfs/hhs064 (application/pdf)
Access to full text is restricted to subscribers.

Related works:
Working Paper: Rare Disasters and Risk Sharing with Heterogeneous Beliefs (2010)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:oup:rfinst:v:25:y:2012:i:7:p:2189-2224

Ordering information: This journal article can be ordered from
https://academic.oup.com/journals

Access Statistics for this article

The Review of Financial Studies is currently edited by Itay Goldstein

More articles in The Review of Financial Studies from Society for Financial Studies Oxford University Press, Journals Department, 2001 Evans Road, Cary, NC 27513 USA.. Contact information at EDIRC.
Bibliographic data for series maintained by Oxford University Press ().