The valuation of catastrophe bonds with exposure to currency exchange risk

Van Son Lai, Mathieu Parcollet and Bernard F. Lamond

International Review of Financial Analysis, 2014, vol. 33, issue C, 243-252

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 process; 3D Brownian motion; Importance sampling; Brownian bridge (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:33:y:2014:i:c:p:243-252

DOI: 10.1016/j.irfa.2014.02.014

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