In his recent Musings on Market blog post “Catastrophe and Consequences for Value” Aswath Damodaran (Stern School of Business, NYU) focuses on the impact of catastrophes on markets and asset values. After illustrating some common themes Aswath poses a couple of questions, one of which is:
- How do you incorporate the risk that catastrophes can occur in the future into valuation models?
“If we define catastrophes as low-probability, high-impact events that affect most companies in an economy,” he answers. “There are three ways in which we can incorporate those events into value:”
- Adjust cash flows for an expected insurance cost
- Use a higher risk premium
- Allow for a higher probability of truncation risk
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