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Diversification through Catastrophe Bonds: Lessons from the Subprime Financial Crisis

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  • Peter Carayannopoulos

    (Financial Services Research Centre, School of Business and Economics, Wilfrid Laurier University, 75 University Av. West, Waterloo, ON, N2L 3C5, Canada. E-mails: pcarayanno@wlu.ca; mperez@wlu.ca)

  • M Fabricio Perez

    (Financial Services Research Centre, School of Business and Economics, Wilfrid Laurier University, 75 University Av. West, Waterloo, ON, N2L 3C5, Canada. E-mails: pcarayanno@wlu.ca; mperez@wlu.ca)

Abstract

Are catastrophe bonds (CAT bonds) zero-beta investments? Are they a valuable new source of diversification for investors? We study these questions by analysing the dynamic relations of CAT bond returns and the returns of the stock, corporate bond and government bond markets. Our multivariate GARCH model results provide evidence that CAT bonds are zero-beta assets only in non-crisis periods. We document that CAT bonds were not immune to the effects of the recent financial crisis. With the collapse of Lehman Brothers, CAT bond returns became significantly correlated with the market. However, the relatively small effect of the crisis on CAT bonds compared with other asset classes make them a valuable source of diversification for investors. Finally, it seems that the improved structures for new CAT bonds issued since 2009 have been positively received by the market, as CAT bond betas returned to pre-crisis levels.

Suggested Citation

  • Peter Carayannopoulos & M Fabricio Perez, 2015. "Diversification through Catastrophe Bonds: Lessons from the Subprime Financial Crisis," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 40(1), pages 1-28, January.
    • Handle: RePEc:pal:gpprii:v:40:y:2015:i:1:p:1-28
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    Citations

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    Cited by:

    1. Karl Demers‐Bélanger & Van Son Lai, 2020. "Diversification benefits of cat bonds: An in‐depth examination," Financial Markets, Institutions & Instruments, John Wiley & Sons, vol. 29(5), pages 165-228, December.
    2. Beaulieu, Marie-Claude & Dufour, Jean-Marie & Khalaf, Lynda & Melin, Olena, 2023. "Identification-robust beta pricing, spanning, mimicking portfolios, and the benchmark neutrality of catastrophe bonds," Journal of Econometrics, Elsevier, vol. 236(1).
    3. Wulan Anggraeni & Sudradjat Supian & Sukono & Nurfadhlina Abdul Halim, 2023. "Catastrophe Bond Diversification Strategy Using Probabilistic–Possibilistic Bijective Transformation and Credibility Measures in Fuzzy Environment," Mathematics, MDPI, vol. 11(16), pages 1-30, August.
    4. Mihovil Anðelinoviæ & Filip Škunca, 2023. "Optimizing insurers investment portfolios: incorporating alternative investments," Zbornik radova Ekonomskog fakulteta u Rijeci/Proceedings of Rijeka Faculty of Economics, University of Rijeka, Faculty of Economics and Business, vol. 41(2), pages 361-389.
    5. Eckhard Platen & David Taylor, 2016. "Loading Pricing of Catastrophe Bonds and Other Long-Dated, Insurance-Type Contracts," Research Paper Series 379, Quantitative Finance Research Centre, University of Technology, Sydney.
    6. Trottier, Denis-Alexandre & Lai, Van Son & Godin, Frédéric, 2019. "A characterization of CAT bond performance indices," Finance Research Letters, Elsevier, vol. 28(C), pages 431-437.
    7. Fabio Pizzutilo & Elisabetta Venezia, 2018. "Are catastrophe bonds effective financial instruments in the transport and infrastructure industries? Evidence from international financial markets," Business and Economic Horizons (BEH), Prague Development Center, vol. 14(2), pages 256-267, April.
    8. Alexis Louaas & Pierre Picard, 2014. "Optimal Insurance For Catastrophic Risk: Theory And Application To Nuclear Corporate Liability," Working Papers hal-01097897, HAL.
    9. Burnecki, Krzysztof & Giuricich, Mario Nicoló & Palmowski, Zbigniew, 2019. "Valuation of contingent convertible catastrophe bonds — The case for equity conversion," Insurance: Mathematics and Economics, Elsevier, vol. 88(C), pages 238-254.
    10. Alexis Louaas and Pierre Picard, 2022. "Optimal Nuclear Liability Insurance," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1).
    11. Tobias Götze & Marc Gürtler, 2022. "Risk transfer beyond reinsurance: the added value of CAT bonds," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 47(1), pages 125-171, January.
    12. Morana, Claudio & Sbrana, Giacomo, 2019. "Climate change implications for the catastrophe bonds market: An empirical analysis," Economic Modelling, Elsevier, vol. 81(C), pages 274-294.
    13. Drobetz, Wolfgang & Schröder, Henning & Tegtmeier, Lars, 2020. "The role of catastrophe bonds in an international multi-asset portfolio: Diversifier, hedge, or safe haven?," Finance Research Letters, Elsevier, vol. 33(C).
    14. Martin Eling & Ruo Jia, 2017. "Recent Research Developments Affecting Nonlife Insurance—The CAS Risk Premium Project 2014 Update," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 20(1), pages 63-77, March.
    15. Peter Carayannopoulos & Olga Kanj & M. Fabricio Perez, 2022. "Pricing dynamics in the market for catastrophe bonds," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 47(1), pages 172-202, January.
    16. Adlane Haffar & Éric Le Fur, 2022. "Dependence structure of CAT bonds and portfolio diversification: a copula-GARCH approach," Journal of Asset Management, Palgrave Macmillan, vol. 23(4), pages 297-309, July.
    17. Ben Ammar, Semir & Braun, Alexander & Eling, Martin, 2015. "Alternative Risk Transfer and Insurance-Linked Securities: Trends, Challenges and New Market Opportunities," I.VW HSG Schriftenreihe, University of St.Gallen, Institute of Insurance Economics (I.VW-HSG), volume 56, number 56.
    18. Bauer, Daniel & Zanjani, George, 2021. "Economic capital and RAROC in a dynamic model," Journal of Banking & Finance, Elsevier, vol. 125(C).

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