Living with ambiguity : pricing mortality-linked securities with smooth ambiguity preferences

Hua CHEN, Michael SHERRIS, Tao SUN, Wenge ZHU

Research output: Journal PublicationsJournal Article (refereed)

8 Citations (Scopus)

Abstract

Mortality is a stochastic process. We have imprecise knowledge about the probability distribution of mortality rates in the future. Mortality risk, therefore, can be defined in a broader term of ambiguity. In this article, we investigate the effects of ambiguity and ambiguity aversion on prices of mortality-linked securities. Ambiguity may arise from parameter uncertainty due to a finite sample of data and inaccurate old-age mortality rates. We compare the price of a mortality bond in three scenarios: (1) no parameter uncertainty, (2) parameter uncertainty with Bayesian updates, and (3) parameter uncertainty with the smooth ambiguity preference. We use the indifference pricing approach to derive the minimum ask price and the maximum bid price, and adopt the economic pricing method to compute the equilibrium price that clears the market. We reveal the connection between the indifference pricing approach and the economic pricing approach and find that ambiguity aversion has a much smaller effect on prices of mortality-linked securities than risk aversion in our example.
Original languageEnglish
Pages (from-to)705-732
Number of pages28
JournalJournal of Risk and Insurance
Volume80
Issue number3
Early online date10 Jul 2013
DOIs
Publication statusPublished - Sep 2013
Externally publishedYes

Fingerprint

Pricing
Mortality
Parameter uncertainty
Ambiguity aversion
Mortality rate
Economics
Indifference pricing
Probability distribution
Mortality risk
Bid
Finite sample
Risk aversion
Scenarios
Stochastic processes
Old age
Equilibrium price

Bibliographical note

Hua Chen acknowledges the financial support from Temple University. Michael Sherris acknowledges the support of ARC Linkage Grant Project LP0883398 Managing Risk with Insurance and Superannuation as Individuals Age with industry partners PwC and APRA and the Australian Research Council Centre of Excellence in Population Ageing Research (project number CE110001029).

Cite this

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abstract = "Mortality is a stochastic process. We have imprecise knowledge about the probability distribution of mortality rates in the future. Mortality risk, therefore, can be defined in a broader term of ambiguity. In this article, we investigate the effects of ambiguity and ambiguity aversion on prices of mortality-linked securities. Ambiguity may arise from parameter uncertainty due to a finite sample of data and inaccurate old-age mortality rates. We compare the price of a mortality bond in three scenarios: (1) no parameter uncertainty, (2) parameter uncertainty with Bayesian updates, and (3) parameter uncertainty with the smooth ambiguity preference. We use the indifference pricing approach to derive the minimum ask price and the maximum bid price, and adopt the economic pricing method to compute the equilibrium price that clears the market. We reveal the connection between the indifference pricing approach and the economic pricing approach and find that ambiguity aversion has a much smaller effect on prices of mortality-linked securities than risk aversion in our example.",
author = "Hua CHEN and Michael SHERRIS and Tao SUN and Wenge ZHU",
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Living with ambiguity : pricing mortality-linked securities with smooth ambiguity preferences. / CHEN, Hua; SHERRIS, Michael; SUN, Tao; ZHU, Wenge.

In: Journal of Risk and Insurance, Vol. 80, No. 3, 09.2013, p. 705-732.

Research output: Journal PublicationsJournal Article (refereed)

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