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The Pricing of Event Risks with Parameter Uncertainty

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  • Kenneth A. Froot

    (Soldiers Field, Harvard Business School, Morgan Hall 391, Boston, MA 02163, USA)

  • Steven E. Posner

    (Goldman Sachs & Co., 85 Broad Street, New York, NY 10004, USA)

Abstract

Financial instruments whose payoffs are linked to exogenous events, such as the occurrence of a natural catastrophe or an unusual weather pattern depend crucially on actuarial models for determining event (e.g., default) probabilities. In many instances, investors appear to receive premiums far in excess of these modeled actuarial probabilities, even for event risks that are uncorrelated with returns on other financial assets. Some have attributed these larger spreads to uncertainty in the probabilities generated by the models. We provide a simple model of such ‘parameter uncertainty’ and demonstrate how it affects rational investors' demand for event risk exposures. We show that while parameter uncertainty does indeed affect bond spreads, it does not tend to increase spreads by much. Indeed, the spread increases due to parameter uncertainty in our numerical examples are on the order of only 1–2 basis points. Moreover, in many instances, including those that have the most sensible correlation settings, parameter uncertainty tends to decrease the size of bond spreads. We therefore argue that parameter uncertainty does not appear to be a satisfactory explanation for high event-risk returns. The Geneva Papers on Risk and Insurance Theory (2002) 27, 153–165. doi:10.1023/A:1021952927149

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Article provided by Palgrave Macmillan in its journal The Geneva Papers on Risk and Insurance Theory.

Volume (Year): 27 (2002)
Issue (Month): 2 (December)
Pages: 153-165

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Handle: RePEc:pal:genrir:v:27:y:2002:i:2:p:153-165

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Cited by:
  1. Yiqun Mou & Lars A. Lochstoer & Michael Johannes, 2011. "Learning about Consumption Dynamics," 2011 Meeting Papers 306, Society for Economic Dynamics.
  2. Turvey, Calum G. & Weersink, Alfons, 2005. "Pricing Weather Insurance with a Random Strike Price: An Application to the Ontario Ice Wine Harvest," 2005 Annual meeting, July 24-27, Providence, RI, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association) 19255, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).

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