Economic Catastrophe Bonds: Inefficient Market or Inadequate Model?
17 Pages Posted: 17 Mar 2012
Date Written: March 15, 2012
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: Suggested Citation