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Rare Event Risk and Heterogeneous Beliefs: The Case of Incomplete Markets

Published online by Cambridge University Press:  18 February 2011

Stephan Dieckmann
Stephan Dieckmann*
Affiliation:
Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104. [email protected]
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Abstract

This paper provides an equilibrium model subject to heterogeneous beliefs about the likelihood of rare events. I explore asset pricing implications in an incomplete capital market and the effects of market completion. Without explicit rare event insurance, investors insure themselves indirectly through the stock and money markets, the risk premium is countercyclical, and flight to quality effects arise. Upon market completion, the risk premium increases as investors increase their exposure to rare event risk. While market completion leads to a more efficient allocation based on investors’ anticipatory utilities, its effect on ex post efficiency is ambiguous.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 46 , Issue 2 , April 2011 , pp. 459 - 488
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2011

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