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    The Probability of Rare Disasters: Estimation and Implications
    10 Dec 2015Working Paper Summaries

    The Probability of Rare Disasters: Estimation and Implications

    by Emil N. Siriwardane
    Emil Siriwardane analyzes the probability for risk of large-scale financial disasters.
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    Author Abstract

    I analyze a rare disasters economy that yields a measure of the risk neutral probability of a macroeconomic disaster, p. A large panel of options data provides strong evidence that p is the single factor driving option-implied jump risk measures in the cross section of firms. This is a core assumption of the rare disasters paradigm. A number of empirical patterns further support the interpretation of p as the risk-neutral likelihood of a disaster. First, standard forecasting regressions reveal that increases in the probability of a disaster lead to economic downturns. Second, disaster risk is priced in the cross section of U.S. equity returns. A zero-cost equity portfolio with exposure to disasters earns risk-adjusted returns of 7.6% per year. Finally, a calibrated version of the model reasonably matches the (i) sensitivity of the aggregate stock market to changes in the likelihood of a disaster and (ii) loss rates of disaster risky stocks during the 2008 financial crisis.

    Paper Information

    • Full Working Paper Text
    • Working Paper Publication Date: November 2015
    • HBS Working Paper Number: 16-061
    • Faculty Unit(s): Finance
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    Emil N. Siriwardane
    Emil N. Siriwardane
    Finnegan Family Associate Professor of Business Administration
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