Pricing Options with Physically Based Exercise and Random Maturity

Carolyn W. Chang, Jack S. K. Chang and Yalan Feng

Journal of Insurance Issues, 2020, vol. 43, issue 1, 59-78

Abstract: Hurricane bonds are uniquely structured to comprise two exercise condi-tions: a physically based condition that the underlying hurricane makes landfall at a pre-specified location and a standard moneyness condition that they end in the money. As the time of landfall is uncertain, their maturities are also uniquely random. Thus extant loss-based catastrophe bond pricing models cannot be directly applied. We propose a novel solution at the nexus of physical science and finance by integrating hurricane risk modeling and option pricing modeling to produce a coupled and physically based hurricane bond pricing model. We apply this methodology to pricing parametric hurricane bonds, featuring a parametric trigger based on physical param-eters related to hurricane tracks, radius, and intensity, as they have become increas-ingly popular in hurricane risk management. As hurricane arrival is underpinned by the discrete, sporadic, and random arrival of hurricane-specific information, we im-plement hurricane risk modeling by Monte Carlo simulation in information time. Our physically based model has the potential advantage of being able to apply to direct hedges against hurricane intensity and size uncertainties at landfall.

Date: 2020
References: Add references at CitEc
Citations:

Downloads: (external link)
http://www.insuranceissues.org/PDFs/431CCF.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wri:journl:v:43:y:2020:i:1:p:59-78

Access Statistics for this article

Journal of Insurance Issues is currently edited by James Barrese

More articles in Journal of Insurance Issues from Western Risk and Insurance Association
Bibliographic data for series maintained by James Barrese ().