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The (Time-Varying) Importance of Disaster Risk

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  • Ivo Welch

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.Editor’s note: This article was reviewed and accepted by Robert Litterman, executive editor at the time the article was submitted.

Suggested Citation

  • Ivo Welch, 2016. "The (Time-Varying) Importance of Disaster Risk," Financial Analysts Journal, Taylor & Francis Journals, vol. 72(5), pages 14-30, September.
    • Handle: RePEc:taf:ufajxx:v:72:y:2016:i:5:p:14-30
    DOI: 10.2469/faj.v72.n5.3
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