Insurance‐linked securities can benefit both issuers and investors; they supply insurance and reinsurance companies with additional risk capital at reasonable prices (with little or no credit risk), and supply excess returns to investors that are uncorrelated with the returns of other financial assets. This article explains the terminology of insurance and reinsurance, the structure of insurance‐linked securities, and provides an overview of major transactions. First, there is a discussion of how stochastic catastrophe modeling has been applied to assess the risk of natural catastrophes, including the reliability and validation of the risk models. Second, the authors compare the risk‐adjusted returns of recent securitizations on the basis of relative value. Compared with high‐yield bonds, catastrophe (“CAT”) bonds have wide spreads and very attractive Sharpe ratios. In fact, the risk‐adjusted returns on CAT bonds dominate high‐yield bonds. Furthermore, since natural catastrophe risk is essentially uncorrelated with market risk, high expected excess returns make CAT bonds high‐alpha assets. The authors illustrate this point and show that a relatively small allocation of insurance‐linked securities within a fixed income portfolio can enhance the expected return and simultaneously decrease risk, without significantly changing the skewness and kurtosis of the return distribution.
EDUARDO CANABARRO is a vice-president in fixed-income derivatives research at Goldman. Sack & Co. in New York.ricing and hedging interest rate-contingent claims s not easy. Unhke the pricing of many equity and foreign exchange derivatives subject to only a few ing and hedging of interest rate derivatives entails the simultaneous modeling of many underlying price processes, namely, the various discount factor processes along the term structure of interest rates.The usual approach is to postulate interest ratesensitive security prices as determined by a small set of state variables (factors) and time. Specifylng the evolution of the state variables as diffusion processes, and imposing a no-arbitrage restriction on the instantaneous returns of a cross-section of interest rate-contingent claims, allows derivation of a deterministic equation for claim prices, usually in the form of a partial differential equation (PDE). The complex dynamics of the evolution of the entire term structure of interest rates is thus summarized as a parsimonious set of state variables and parameters to which quantitative techniques can be applied. Empirical studies shed some light on the minimum number of factors that might be necessary to capture the relevant dynamics of the term structure of interest rates. Litterman and Scheinkman [1991] find that at least two factors are necessary to explain changes in zero-coupon ylelds over terms up to thirty years. The most important factor is associated with level shifts of the yield curve. The second factor is associated with changes in its slope. We show elsewhere how much hedging accuracy can be improved when instruments spanning those two factors are used in bond replicating strategies (see Canabarro [1993]).An expanded number of factors of course entail P well-defined underlying price processes, the pric-SEPTEMBER 1995
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