TAILIEUCHUNG - CATASTROPHE RISK BONDS

This article examines the pricing of catastrophe risk bonds. Catastrophe risk cannot be hedged by traditional securities. Therefore, the pricing of catastrophe risk bonds requires an incomplete markets setting, and this creates special difficulties in the pricing methodology. The authors briefly discuss the theory of equilibrium pricing and its relationship to the standard arbitrage-free valuation framework. Equilibrium pricing theory is used to develop a pricing method based on a model of the term structure of interest rates and a probability structure for the catastrophe risk. This pricing methodology can be used to assess the default spread on catastrophe risk bonds relative to traditional defaultable securities | Catastrophe Risk Bonds Samuel H. Cox and Hal W. Pedersenf Abstract This article examines the pricing of catastrophe risk bonds. Catastrophe risk cannot be hedged by traditional securities. Therefore the pricing of catastrophe risk bonds requires an incomplete markets setting and this creates special difficulties in the pricing methodology. The authors briefly discuss the theory of equilibrium pricing and its relationship to the standard arbitrage-free valuation framework. Equilibrium pricing theory is used to develop a pricing method based on a model of the term structure of interest rates and a probability structure for the catastrophe risk. This pricing methodology can be used to assess the default spread on catastrophe risk bonds relative to traditional defaultable securities. It is indeed most wonderful to witness such desolation produced in three minutes of time. Charles Darwin commenting on the February 20 1835 earthquake in Chile. 1. Introduction Catastrophe risk bonds provide a mechanism for direct transfer of catastrophe risk to capital markets in contrast to transfer through a traditional reinsurance company. The bondholder s cash flows coupon or principal from these bonds are linked to particular catastrophic events such as earthquakes hurricanes or floods. Although several deals involving catastrophe risk bonds have been announced recently the concept has been around awhile. Goshay and Sandor 1973 proposed trading reinsurance futures in 1973. In 1984 Svensk Exportkredit launched a private placement of earthquake bonds that are immediately redeemable if a major earthquake hits Japan Ollard 1985 . Insurers in Japan bought the bonds agreeing to accept lower-than-normal coupons in exchange for the right to put the bonds back to the issuer at face value if an earthquake Samuel H. Cox . . is a Professor of Actuarial Science in the Department of Risk Management and Insurance at Georgia State University . Box 4036 Atlanta GA 30302-4036 e-mail .

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