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NBER Working Papers and Publications
|February 2001||The Pricing of Event Risks with Parameter Uncertainty|
with Kenneth A. Froot: w8106
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. In...
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.