Valuing Catastrophe Bonds by Monte Carlo Simulations

Posted: 26 Oct 2004

See all articles by Victor Vaugirard

Victor Vaugirard

TEAM-CNRS, University of Paris at Sorbonne

Abstract

This paper reports fairly accurate simulations of insurance-linked securities within an arbitrage-free framework, while accounting for catastrophic events and allowing for stochastic interest rates. Assessing these contingent claims exhibits features of instability rooted in the discontinuity of the payoffs of binary options around their threshold, which is magnified by possible jumps in their underlying dynamics. The error made while simulating path-dependent digital options whose underlyings obey geometric Brownian motion is used to control the estimation of digital options whose underlyings follow jump-diffusion processes. Comparative statics results highlight the hump shape of the term structure of catbond yield spreads.

Keywords: Catastrophe bonds, digital options, jump-diffusion process, mean-reverting process, variance reduction

JEL Classification: C15, C63, G12, G13

Suggested Citation

Vaugirard, Victor, Valuing Catastrophe Bonds by Monte Carlo Simulations. Available at SSRN: https://ssrn.com/abstract=606063

Victor Vaugirard (Contact Author)

TEAM-CNRS, University of Paris at Sorbonne ( email )

Maison des Sciences Economiques
106-112 Boulevard de l'Hôpital
Paris, F-75013
France

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