Economic Catastrophe Bonds

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