UNDERSTANDING CATASTROPHIC INFORMATION IMPLIED BY CAT BONDS PRICES IN THE SECONDARY MARKET

Abstract

This paper proposes a simple and interpretable discrete-time model for bonds using a combination of risk-neutral probability transform and econometric approaches. The model states that the value of the bond is dependent on the risk-free rate, time to maturity, cashflows and a risk premium term. The risk premium consists of a survival probability which incorporates an investor speculation term. This model is applied to catastrophe and specific corporate bonds to obtain the price-implied one-month survival probability and annualized default probability. We find that the default probability is dependent on some combination of the Exposure and Vulnerability indices obtained from the World Risk Index dataset. Additionally, we find that this survival probability is uncorrelated between catastrophe and corporate bonds, which is supporting evidence that catastrophe bonds separate catastrophic risks from credit risks.