The (Time-Varying) Importance of Disaster Risk. Issue 5 (1st September 2016)

• Record Type: Journal Article
• Authors: Welch, Ivo
• Is Part Of: Financial analysts journal. Volume 72:Issue 5(2016)
• Page Start: 14
• Page End: 30
• Publication Date: 2016-09-01
• Subjects: Investment analysis -- Periodicals; Investment analysis; HW_FM; Periodicals; Electronic journals; 332.6
• DOI: 10.2469/faj.v72.n5.3
• Languages: English
• ISSNs: 0015-198X

Abstract

Abstract : How much of the historical 7% per year equity risk premium could have been risk compensation for disasters that just happened not to have occurred? The answer can be found in below-the-money put prices, which would have protected against such disasters. Using the cost of rolling over one-month index put options, I show that the maximum possible premium for crash risk could not have accounted for more than about 2% per year, thus leaving about 5% per year for reasons other than sudden disasters. I also provide a novel "conservative diffuse prior" approach for dealing with black swan risk. Abstract : Editor's note: This article was reviewed and accepted by Robert Litterman, executive editor at the time the article was submitted.