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How would you model and price the risk of Covid-19 pandemic? These large cost low probability events with very little history seems to pose a particular challenge when quantitatively modeling and pricing the risk. What types of models have you used? What are the inputs to your models?

Taleb is calling this a White Swan--a predictable event. How should one hedge this risk? What type of tail risk mitigation steps/programs should one use? What type of options strategies would be most effective and could one use?

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    $\begingroup$ Taleb calls the unpredictable events Black Swans. He calls pandemic a White Swan--a predictable event. $\endgroup$ – AlRacoon Apr 17 '20 at 19:11
  • $\begingroup$ Correct, Sorry called 'swan' white swan! This is usually dealt with via Stress testing - a standard stress scenario in many international banks.Agree these are not as rare as Taleb's swans, epidemics literature gets quite close to assigning these a definite probability, but then the modelling is done via stress testing because so many assumptions go into the models, and one cannot predict or control how others will react. $\endgroup$ – Magic is in the chain Apr 17 '20 at 19:15
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Concerning the hedging, you can use so-called catastrophe bonds. They are often issued by insurers and reinsurers, development banks and I can imagine issue by a pharma company. Funds raised from these bonds are put on separated account where they waint until a catastrophe (specified in the bond documentation) occurs. When this happens, the issuer can use funds on the account to treat consequences of the catastrophe. Sometimes there is a provision that in case of the catastrophe, the issuer will return no or smaller nominal to an investor. In case the catastrophe does not occur, the issuer returns whole nominal plus interest to the investor.

If we look at a normal investor (e.g. central bank, mutual fund etc.), a pandemic is very similar to any financial crisis. So an approach to hedging depends on how much risk-averse the investor is. You can for example use negative correlation between high quality government bonds and equities - when a financial crisis break out, equities would lose but there would be risk-off behavior and fly to government bonds whose price would increase.

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    $\begingroup$ In the spirit of catastrophe bonds, there are actually pandemic bonds, which were issued several years ago by the World Bank. Although they are heavily criticized in the current situation, they might be a useful tool to quantify these types of risks. $\endgroup$ – Evgenii Apr 19 '20 at 14:56

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