A0590
Title: Optimal consumption and savings decisions with disastrous income risk: Revisiting Rietz's rare disaster risk hypothesis
Authors: Chusu He - University of Bath (United Kingdom) [presenting]
Alistair Milne - Loughborough University (United Kingdom)
Seyoung Park - University of Nottingham (United Kingdom)
Abstract: An analytically tractable framework is developed for optimal consumption and savings decisions with disastrous income risk. In the context of Rietz's rare disaster risk hypothesis, we explain high-risk premia through a new channel of idiosyncratic income risk premium. The effects of idiosyncratic income risk premium are revealed in the agent's optimal decisions by the precautionary savings, thereby making the agent consume less and save more. We also investigate the important role of insurance with a focus on the recovery of income in a disaster. We highlight how the extent of the disastrous income risk to which the agent is exposed and her income recovery in the income shock jointly affect the agent's optimal decisions. Overall, the availability of insurance can be particularly important for both the poor and the wealthy in the sense that they could even consume more, save less, and invest more in the income shock as long as their future income is (partly) recovered.
