Articlegreen2002

Pricing Default‐Risky CAT Bonds With Moral Hazard and Basis Risk

175 citations0/0 files storedJournal of Risk & Insurance

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Insurance and Financial Risk Management Stochastic processes and financial applications Credit Risk and Financial Regulations

Abstract

This article develops a contingent claim model to price a default-risky, catastrophe-linked bond. This model incorporates stochastic interest rates and more generic loss processes and allows for practical considerations of moral hazard, basis risk, and default risk. The authors compute default-free and default-risky CAT bond prices by using the Monte Carlo method. The results show that both moral hazard and basis risk drive down the bond prices substantially; these effects should not be ignored in pricing the CAT bonds. The authors also show how the bond prices are related to catastrophe occurrence intensity, loss volatility, trigger level, the issuing firm's capital position, debt structure, and interest rate uncertainty.

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References

1985A Theory of the Term Structure of Interest Rates 1977An equilibrium characterization of the term structure 1976Option pricing when underlying stock returns are discontinuous 1976The valuation of options for alternative stochastic processes 1981Martingales and stochastic integrals in the theory of continuous trading 1977An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory 1982Approximate option valuation for arbitrary stochastic processes 1991A Quick Algorithm for Pricing European Average Options

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