Economic Catastrophe Bonds: Inefficient Market or Inadequate Model?

17 Pages Posted: 17 Mar 2012

See all articles by Haitao Li

Haitao Li

University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business

Feng Zhao

University of Texas at Dallas - Jindal School of Management

Date Written: March 15, 2012

Abstract

Coval, Jurek, and Stafford (2009, CJS hereafter) claim that senior CDX tranches, which resemble economic catastrophe bonds, are overpriced relative to index options. We show that this result is due to their problematic calibration procedure and restrictive model assumptions. A simple correction of the calibration procedure reduces the overpricing of the most senior tranche by 80%. Moreover, an extremely parsimonious model with essentially no free parameters proposed by Hull and White (2004) can price CDX tranches and index options well. Therefore, it is difficult to conclude that CDX tranches are mispriced simply because CJS cannot price them.

Keywords: CDX index and tranches, copula model, economic catastrophe risk, fat tail

JEL Classification: C11, E43, G11

Suggested Citation

Li, Haitao and Zhao, Feng, Economic Catastrophe Bonds: Inefficient Market or Inadequate Model? (March 15, 2012). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=2023717 or http://dx.doi.org/10.2139/ssrn.2023717

Haitao Li (Contact Author)

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-615-5475 (Phone)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Feng Zhao

University of Texas at Dallas - Jindal School of Management ( email )

800 W. Campbell Rd. SM 31
Richardson, TX 75080
United States
972-883-5815 (Phone)

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