The Pricing of Event Risks with Parameter Uncertainty

Kenneth A. Froot, Steven E. Posner

NBER Working Paper No. 8106
Issued in February 2001
NBER Program(s):Asset Pricing, Corporate Finance

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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Document Object Identifier (DOI): 10.3386/w8106

Published: Kenneth A. Froot & Steven E. Posner, 2002. "The Pricing of Event Risks with Parameter Uncertainty," The Geneva Papers on Risk and Insurance Theory, vol 27(2), pages 153-165.

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