Working Paper: NBER ID: w16035
Authors: Hui Chen; Scott Joslin; Ngockhanh 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.
Keywords: No keywords provided
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Heterogeneous beliefs about disasters (D80) | Risk sharing among agents (D82) |
| Risk sharing among agents (D82) | Equity premium (G19) |
| Wealth distribution (D31) | Equity premium (G19) |
| Disagreement among agents (D80) | Equity premium (G19) |
| Wealth concentration among agents with similar beliefs (D30) | Disaster risk premium (H84) |
| Wealth distribution (D31) | Risk sharing arrangements (G32) |
| Risk exposure (G22) | Risk premium (G19) |
| Size of disaster insurance market (G52) | Equity premium (G19) |