Living with ambiguity : pricing mortality-linked securities with smooth ambiguity preferences
Document Type
Journal article
Source Publication
Journal of Risk and Insurance
Publication Date
8-2013
Volume
80
Issue
3
First Page
705
Last Page
732
Publisher
Wiley-Blackwell Publishing, Inc.
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.
DOI
10.1111/j.1539-6975.2013.12001.x
Print ISSN
00224367
E-ISSN
15396975
Funding Information
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). {LP0883398, CE110001029}
Publisher Statement
Copyright © The Journal of Risk and Insurance, 2013
Access to external full text or publisher's version may require subscription.
Full-text Version
Publisher’s Version
Language
English
Recommended Citation
Chen, H., Sherris, M., Sun, T., & Zhu, W. (2013). Living with ambiguity: Pricing mortality-linked securities with smooth ambiguity preferences. The Journal of Risk and Insurance, 80(3), 705-732. doi: 10.1111/j.1539-6975.2013.12001.x