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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

Suggested Citation

  • Kenneth A. Froot & Steven E. Posner, 2002. "The Pricing of Event Risks with Parameter Uncertainty," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 27(2), pages 153-165, December.
  • Handle: RePEc:pal:genrir:v:27:y:2002:i:2:p:153-165
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    Cited by:

    1. repec:eee:apmaco:v:309:y:2017:i:c:p:68-84 is not listed on IDEAS
    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 19255, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    3. Yiqun Mou & Lars A. Lochstoer & Michael Johannes, 2011. "Learning about Consumption Dynamics," 2011 Meeting Papers 306, Society for Economic Dynamics.

    More about this item

    JEL classification:

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

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