How Financial Theory Applies to Catastrophe-Linked Derivatives. An Empirical Test of Several Pricing Models

The Journal of Risk and Insurance, Vol. 66, No. 4, pp. 551-582, 1999

Posted: 30 Aug 2007

See all articles by Alejandro Balbás

Alejandro Balbás

Universidad Carlos III de Madrid - Department of Business Administration

Iñaki Rodríguez-Longarela

Stockholm University - Stockholm Business School; UiT-The Arctic University of Norway - School of Business and Economics

Julio J. Lucia

University of Valencia - Faculty of Economics

Abstract

This paper discusses the PCS Catastrophe Insurance Option Contracts, providing empirical support on the level of correspondence between real quotes and standard financial theory. The highest possible precision is incorporated since the real quotes are perfectly synchronized and the bid-ask spread is always considered. A static setting is assumed and the main topics of arbitrage, hedging, and portfolio choice are involved in the analysis. Three significant conclusions are reached. First, the catastrophe derivatives may often be priced by arbitrage methods, and the paper provides some examples of practical strategies that were available in the market. Second, hedging arguments also yield adequate criteria to price the derivatives, and some real examples are provided as well. Third, in a variance aversion context many agents could be interested in selling derivatives to invest the money in stocks and bonds. These strategies show a suitable level in the variance for any desired expected return. Furthermore, the methodology here applied seems to be quite general and may be useful to price other derivative securities. Simple assumptions on the underlying asset behavior are the only required conditions.

Suggested Citation

Balbás de la Corte, Alejandro and Rodríguez Longarela, Iñaki and Lucia, Julio J., How Financial Theory Applies to Catastrophe-Linked Derivatives. An Empirical Test of Several Pricing Models. The Journal of Risk and Insurance, Vol. 66, No. 4, pp. 551-582, 1999. Available at SSRN: https://ssrn.com/abstract=1010583

Alejandro Balbás de la Corte

Universidad Carlos III de Madrid - Department of Business Administration ( email )

Calle Madrid 126
Getafe, Madrid, Madrid 28903
Spain

Iñaki Rodríguez Longarela (Contact Author)

Stockholm University - Stockholm Business School ( email )

Stockholm
Sweden

UiT-The Arctic University of Norway - School of Business and Economics ( email )

Tromsø, 9037
Norway

Julio J. Lucia

University of Valencia - Faculty of Economics ( email )

Valencia, E-46022
Spain

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