By Force of Nature: Explaining the Yield Spread on Catastrophe Bonds

43 Pages Posted: 14 Jan 2008 Last revised: 30 Mar 2010

See all articles by Stephan Dieckmann

Stephan Dieckmann

University of Pennsylvania - Finance Department

Date Written: March 1, 2010

Abstract

This paper re-examines to which extent catastrophe bond prices can be explained via investor preferences. I show that cat bond spreads equal between two and three times expected losses after controlling for bond-specific characteristics. At the occurrence of Katrina, the model predicts a 15-20% increase in the cost of capital of reinsurance companies and plausible degrees of comovement among different perils. The driving force behind the model is a habit process, in that catastrophes are rare economic shocks that could bring investors closer to their subsistence level. Such preferences may also explain why catastrophe bonds offer higher yield spreads compared to equally-rated corporate bonds.

Keywords: Fixed Income, Insurance-Linked Security, Natural Disasters, Katrina, External Habit

JEL Classification: D51, D53, G12, G22

Suggested Citation

Dieckmann, Stephan, By Force of Nature: Explaining the Yield Spread on Catastrophe Bonds (March 1, 2010). Available at SSRN: https://ssrn.com/abstract=1082879 or http://dx.doi.org/10.2139/ssrn.1082879

Stephan Dieckmann (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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