Some Quantitative Limits For Disaster Risk and Equity Premium Estimates

With 87 years of volatile stock return data, disaster-risk models operate in a narrow band between an ability to lower the equity premium from the historical geometric 5.9% per annum to a more model-appealing 4%, and an equity premium that can no longer be distinguished from zero (risk neutrality) at conventional statistical significance levels. Available below-the-money index option prices limit the total compound effect of unobserved disaster risk to about –70 to –80%. Consequently, disaster risk cannot account for more than a 2–3% drag. Ironically, if we had observed a drop of –80% magnitude (or once we will), we will no longer be able to consider the equity premium estimate to be different from zero at conventional statistical significance levels. Thus, a disaster premium of 1-2% seems most appealing, leaving other factors or simple ordinary sampling variation to explain the remaining 4-5%.