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Rare disasters and risk sharing with heterogeneous beliefs

Author: Hui Chen; Scott Joslin; Ngoc-Khanh Tran; National Bureau of Economic Research.
Publisher: Cambridge, Mass. : National Bureau of Economic Research, ©2010.
Series: Working paper series (National Bureau of Economic Research), no. 16035.
Edition/Format:   eBook : Document : EnglishView all editions and formats
Summary:
Although the threat of rare economic disasters can have large effect on asset prices, difficulty in inference regarding both their likelihood and severity provides the potential for disagreements among investors. Such disagreements lead investors to insure each other against the types of disasters each one fears the most. Due to the highly nonlinear relationship between consumption losses in a disaster and the risk  Read more...
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Additional Physical Format: Print version:
Chen, Hui.
Rare disasters and risk sharing with heterogeneous beliefs.
Cambridge, Mass. : National Bureau of Economic Research, ©2010
(DLC) 2010655925
Material Type: Document, Internet resource
Document Type: Internet Resource, Computer File
All Authors / Contributors: Hui Chen; Scott Joslin; Ngoc-Khanh Tran; National Bureau of Economic Research.
OCLC Number: 635509276
Description: 1 online resource (50 pages) : illustrations.
Series Title: Working paper series (National Bureau of Economic Research), no. 16035.
Responsibility: Hui Chen, Scott Joslin, Ngoc-Khanh Tran.

Abstract:

Although the threat of rare economic disasters can have large effect on asset prices, difficulty in inference regarding both their likelihood and severity provides the potential for disagreements among investors. Such disagreements lead investors to insure each other against the types of disasters each one fears the most. Due to the highly nonlinear relationship between consumption losses in a disaster and the risk premium, a small amount of risk sharing can significantly attenuate the effect that disaster risk has on the equity premium. We characterize the sensitivity of risk premium to wealth distribution analytically. Our model shows that time variation in the wealth distribution and the amount of disagreement across agents can both lead to significant variation in disaster risk premium. It also highlights the conditions under which disaster risk premium will be large, namely when disagreement across agents is small or when the wealth distribution is highly concentrated in agents fearful of disasters. Finally, the model predicts an inverse U-shaped relationship between the equity premium and the size of the disaster insurance market.

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