Economic Catastrophe Bonds

46 Pages Posted: 26 Jun 2007 Last revised: 13 Apr 2008

Joshua D. Coval

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Jakub W. Jurek

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Erik Stafford

Harvard Business School - Finance Unit

Date Written: April 2008

Abstract

The central insight of asset pricing is that a security's value depends on both its distribution of payoffs across economic states and state prices. In fixed income markets, many investors focus exclusively on estimates of expected payoffs, such as credit ratings, without considering the state of the economy in which default is likely to occur. Such investors are likely to be attracted to securities whose payoffs resemble those of economic catastrophe bonds - bonds that default only under severe economic conditions. We show that many structured finance instruments can be characterized as economic catastrophe bonds, but offer far less compensation than alternatives with comparable payoff profiles. We argue that this difference arises from the willingness of rating agencies to certify structured products with a low default likelihood as safe and from a large supply of investors who view them as such.

Keywords: bond pricing, structured finance, credit derivatives, collateralized debt obligation (CDO), state price density, Arrow-Debreu

JEL Classification: G12, G13

Suggested Citation

Coval, Joshua D. and Jurek, Jakub W. and Stafford, Erik, Economic Catastrophe Bonds (April 2008). HBS Finance Working Paper No. 07-102. Available at SSRN: https://ssrn.com/abstract=995249 or http://dx.doi.org/10.2139/ssrn.995249

Joshua D. Coval (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jakub W. Jurek

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-1588 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Erik Stafford

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-8064 (Phone)
617-496-7357 (Fax)

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