The (Time-Varying) Importance of Disaster Risk

Ivo Welch

Financial Analysts Journal, 2016, vol. 72, issue 5, 14-30

Abstract: How much of the historical 7% per year equity risk 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 such disasters. Using the cost of rolling over one-month index put options, I show that the maximum possible premium for crash risk could not have accounted for more than about 2% per year, thus leaving about 5% per year for reasons other than sudden disasters. I also provide a novel “conservative diffuse prior” approach for dealing with black swan risk.Editor’s note: This article was reviewed and accepted by Robert Litterman, executive editor at the time the article was submitted.

Date: 2016
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DOI: 10.2469/faj.v72.n5.3

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