TY  - JOUR
AU  - Froot,Kenneth A.
AU  - Posner,Steven E.
TI  - The Pricing of Event Risks with Parameter Uncertainty
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 8106
PY  - 2001
Y2  - February 2001
UR  - http://www.nber.org/papers/w8106
L1  - http://www.nber.org/papers/w8106.pdf
N1  - Author contact info:
Kenneth A. Froot
Graduate School of Business
Harvard University
Soldiers Field
Boston, MA 02163
Tel: 617/495-6677
Fax: 617/496-7357
E-Mail: kfroot@hbs.edu

Steven Posner
Goldman, Sachs & Co.
85 Broad St., 29th Floor
New York, NY 10004
E-Mail: steven.posner@gs.com
AB  - 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.
ER  -