Research On Catastrophe Bond Pricing Based On Arbitrage Method

In recent years, many countries and regions around the world had affected bynatural catastrophe risk events and the frequency and severity were gradually expanding.This has resulted in unprecedented pressure to traditional insurance market. For facingcatastrophe risk with low frequency and high losses, insurance market is restricted bylacking of underwriting capacity and other factors,so that the catastrophe risk can not befully transferred and dispersed in insurance market. Therefore, people gradually turntheir attentionon the huge capital market, and then catastrophe risk securitizationproducts have emerged.The strength of China’s insurance market is weak in catastrophe risk management,and the research of catastrophe risk securitizationis still in its infancy in China,not tomention the development of a catastrophe risk derivatives market similar to abroad. Onthe other hand, China is a natural disaster-prone country. The scale losses caused bynatural disasters are more than ten billion RMB annually.The existing disaster reliefsystem that mainly relies on financial allocation will causeenormous financial pressureon the government. Thus, China urgently needs to find new ways forcatastrophe riskmanagement.This paper started with the reality situations of catastrophe risk losses in domesticand abroad. It described many inadequacies of traditional catastrophe insurance incatastrophe risk management and analyzed the generation background of catastropherisk securitization. Then it further introduced some common alternative risk transfer(ART) instruments, such as catastrophe futures, catastrophe options, catastrophe bonds,catastrophe swaps and so on, especially focused on the study of catastrophe bonds. Onthe basis of the literature review of catastrophe bonds, it proposed the main study topicof this paper, i.e. the study of pricing catastrophe bonds.Catastrophe bond is a kind of risk-linked bond. The terminal payoff of catastrophebonds depends on whether the catastrophe risk pre-specified by contracts happened in acertain period of time, and the pricing difficulty for those bonds lies in handling with thecatastrophe risk. This paper followed the arbitrage pricing idea of Vaugirard. Itintroduced a fixed market price of risk, which was used to measure the required extraincome of investors due to they bear the risk of volatility of price,into the pricing modelof this paper,and combined with the Vasicek stochastic interest rate model to deduce an explicit expression formula for zero-coupon catastrophe bonds pricing under thecondition of an equivalent martingale. Then the resulting formula was applied to theempirical analysis of the loss data generated by earthquakes in China in1969-2007viaMonte Carlo simulation algorithm.Two features were found through the simulation.First, the zero-coupon catastrophe bond price is inversely proportional to thewrite-down coefficient, i.e. the greater the value of is, the lower the bond priceshould be, and vice versa. Second, the price of zero-coupon catastrophe bond isproportional to the threshold of the trigger, i.e. the larger the value of is, thehigher the bond price should be.This paper finally showed some possible research directions for pricing catastrophebonds based on the resultsof the article and prospected the issuance of catastrophe risksecuritization products in China.