The Pricing of Event Risks with Parameter Uncertainty
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.
|Date of creation:||Feb 2001|
|Publication status:||published as Kenneth A. Froot & Steven E. Posner, 2002. "The Pricing of Event Risks with Parameter Uncertainty," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 27(2), pages 153-165, December.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:8106. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.