The proposal comprises two themes that are linked by a concern for the importance of extreme events, in financial markets and more generally. Work on the two themes is ongoing throughout the time span of the project.
Aside from its intrinsic academic interest, the first theme, Option-implied measures of market beliefs, will have important applications for the financial industry and for policymakers and regulators. The goal is to develop ways of using observable asset-price data to infer the beliefs of market participants about various quantities that are central to financial economics, such as (i) the equity premium; (ii) the forward-looking autocorrelation of the market (i.e. time-series momentum); (iii) the risk premia associated with individual stocks; (iv) measures of correlation between stocks; and (v) measures of asymmetric risk, such as the forward-looking probability of a significant downward jump in the stock market over some prescribed time period.
Improving understanding of these issues will help policymakers as they react to market turbulence, investors as they interpret market gyrations and plan savings (for retirement or otherwise); and more generally will help society allocate capital more efficiently.
The second theme, Policy responses to catastrophes: The economics of Scylla and Charybdis, proposes a framework for thinking about government policy regarding the various potential catastrophes that confront society. (An incomplete list would include climate change; public health catastrophes such as mega-viruses; nuclear or bio-terrorism; and meteorite strikes. The legal scholar Richard Posner (2004) provides more examples of potential catastrophes and argues that society fails to take such risks sufficiently seriously.) This work is joint with Robert S. Pindyck of MIT, who is one of the world’s leading experts on the economics of climate change; our collaboration started at the TIGER Forum on environmental economics in Toulouse, organized by Christian Gollier. The goal is to provide a framework to help policymakers, faced with multiple different types of potential catastrophe, to decide how society’s limited resources should best be used to alleviate the risks of severe catastrophes.
