The Valuation of Catastrophe Bonds with Exposure to Currency Exchange Risk
30 Pages Posted: 24 Feb 2014
Date Written: February 22, 2014
Abstract
In this paper, we present a new model that takes an arbitrage approach to the valuation of catastrophic risk bonds (CAT bonds). The model considers the sponsor’s exposure to currency exchange risk and the risk of catastrophic events. We use a jump-diffusion process for catastrophic events, a three-dimensional stochastic process for the exchange rate and domestic and foreign interest rates, and a hedging cost for the currency risk to derive a semi-closed-form formula for the CAT bond price. We also extend to three factors Joshi and Leung’s (2007) Monte Carlo simulation approach to obtain numerical results showing the following: in addition to catastrophic risk, the CAT bond price is affected mainly by the volatility of the exchange rate and its correlations with domestic and foreign interest rates. The first two factors have a negative impact while the third has a positive impact.
Keywords: CAT bond valuation, catastrophic and currency exchange risk, jump-diffusion
JEL Classification: G130, G170, G220
Suggested Citation: Suggested Citation