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The Pricing of Event Risks with Parameter Uncertainty

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Author Info
Kenneth A. Froot
Steven E. Posner

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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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8106.

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Date of creation: Feb 2001
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Handle: RePEc:nbr:nberwo:8106

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G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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