IDEAS home Printed from https://ideas.repec.org/a/bla/jrinsu/v90y2023i2p283-328.html
   My bibliography  Save this article

Trading and liquidity in the catastrophe bond market

Author

Listed:
  • Markus Herrmann
  • Martin Hibbeln

Abstract

We provide first insights into secondary market trading, liquidity determinants, and the liquidity premium of catastrophe bonds. Based on transaction data from TRACE (Trade Reporting and Compliance Engine), we find that cat bonds are traded less frequently during the hurricane season and more often close to maturity. Trading activity indicates that the market is dominated by brokers without a proprietary inventory. Liquidity is high in periods of high trading activity in the overall market and for bonds with low default risk or close to maturity, which results from lower order processing costs. Finally, using realized bid–ask spreads as a liquidity measure, we find that on average, 21% of the observable yield spread on the cat bond market is attributable to the liquidity premium, with a magnitude of up to 141 bps for high‐risk bonds.

Suggested Citation

  • Markus Herrmann & Martin Hibbeln, 2023. "Trading and liquidity in the catastrophe bond market," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 90(2), pages 283-328, June.
    • Handle: RePEc:bla:jrinsu:v:90:y:2023:i:2:p:283-328
    DOI: 10.1111/jori.12407
    as

    Download full text from publisher

    File URL: https://doi.org/10.1111/jori.12407
    Download Restriction: no
    File URL: https://libkey.io/10.1111/jori.12407?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Acharya, Viral V. & Pedersen, Lasse Heje, 2005. "Asset pricing with liquidity risk," Journal of Financial Economics, Elsevier, vol. 77(2), pages 375-410, August.
    2. Bai, Jennie & Goldstein, Robert S. & Yang, Fan, 2020. "Is the credit spread puzzle a myth?," Journal of Financial Economics, Elsevier, vol. 137(2), pages 297-319.
    3. Hui Chen & Rui Cui & Zhiguo He & Konstantin Milbradt, 2018. "Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle," Review of Financial Studies, Society for Financial Studies, vol. 31(3), pages 852-897.
    4. Cortés, Kristle Romero & Strahan, Philip E., 2017. "Tracing out capital flows: How financially integrated banks respond to natural disasters," Journal of Financial Economics, Elsevier, vol. 125(1), pages 182-199.
    5. Zhao, Yang & Yu, Min-Teh, 2019. "Measuring the liquidity impact on catastrophe bond spreads," Pacific-Basin Finance Journal, Elsevier, vol. 56(C), pages 197-210.
    6. Zhiguo He & Konstantin Milbradt, 2014. "Endogenous Liquidity and Defaultable Bonds," Econometrica, Econometric Society, vol. 82(4), pages 1443-1508, July.
    7. Krista Schwarz, 2019. "Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads," Review of Finance, European Finance Association, vol. 23(3), pages 557-597.
    8. Gehde-Trapp, Monika & Schuster, Philipp & Uhrig-Homburg, Marliese, 2018. "The Term Structure of Bond Liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(5), pages 2161-2197, October.
    9. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    10. Goyenko, Ruslan & Subrahmanyam, Avanidhar & Ukhov, Andrey, 2011. "The Term Structure of Bond Market Liquidity and Its Implications for Expected Bond Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(1), pages 111-139, February.
    11. David Döhrmann & Marc Gürtler & Martin Hibbeln, 2017. "Insured Loss Inflation: How Natural Catastrophes Affect Reconstruction Costs," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 84(3), pages 851-879, September.
    12. Shane A. Corwin & Paul Schultz, 2012. "A Simple Way to Estimate Bid‐Ask Spreads from Daily High and Low Prices," Journal of Finance, American Finance Association, vol. 67(2), pages 719-760, April.
    13. Braun, Alexander & Ben Ammar, Semir & Eling, Martin, 2019. "Asset pricing and extreme event risk: Common factors in ILS fund returns," Journal of Banking & Finance, Elsevier, vol. 102(C), pages 59-78.
    14. Koetter, Michael & Noth, Felix & Rehbein, Oliver, 2020. "Borrowers under water! Rare disasters, regional banks, and recovery lending," Journal of Financial Intermediation, Elsevier, vol. 43(C).
    15. Dick-Nielsen, Jens & Feldhütter, Peter & Lando, David, 2012. "Corporate bond liquidity before and after the onset of the subprime crisis," Journal of Financial Economics, Elsevier, vol. 103(3), pages 471-492.
    16. Semir Ben Ammar, 2020. "Catastrophe Risk and the Implied Volatility Smile," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 87(2), pages 381-405, June.
    17. John Y. Campbell & Glen B. Taksler, 2003. "Equity Volatility and Corporate Bond Yields," Journal of Finance, American Finance Association, vol. 58(6), pages 2321-2350, December.
    18. Friewald, Nils & Jankowitsch, Rainer & Subrahmanyam, Marti G., 2012. "Illiquidity or credit deterioration: A study of liquidity in the US corporate bond market during financial crises," Journal of Financial Economics, Elsevier, vol. 105(1), pages 18-36.
    19. Richard C. Green & Burton Hollifield & Norman Schürhoff, 2007. "Financial Intermediation and the Costs of Trading in an Opaque Market," The Review of Financial Studies, Society for Financial Studies, vol. 20(2), pages 275-314.
    20. Raphael Schestag & Philipp Schuster & Marliese Uhrig-Homburg, 2016. "Measuring Liquidity in Bond Markets," Review of Financial Studies, Society for Financial Studies, vol. 29(5), pages 1170-1219.
    21. Marc Gürtler & Martin Hibbeln & Christine Winkelvos, 2016. "The Impact of the Financial Crisis and Natural Catastrophes on CAT Bonds," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 83(3), pages 579-612, September.
    22. Acharya, Viral V. & Amihud, Yakov & Bharath, Sreedhar T., 2013. "Liquidity risk of corporate bond returns: conditional approach," Journal of Financial Economics, Elsevier, vol. 110(2), pages 358-386.
    23. Long Chen & David A. Lesmond & Jason Wei, 2007. "Corporate Yield Spreads and Bond Liquidity," Journal of Finance, American Finance Association, vol. 62(1), pages 119-149, February.
    24. Marcello Galeotti & Marc Gürtler & Christine Winkelvos, 2013. "Accuracy of Premium Calculation Models for CAT Bonds—An Empirical Analysis," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 80(2), pages 401-421, June.
    25. Lane, Morton N., 2000. "Pricing Risk Transfer Transactions1," ASTIN Bulletin, Cambridge University Press, vol. 30(2), pages 259-293, November.
    26. Roll, Richard, 1984. "A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market," Journal of Finance, American Finance Association, vol. 39(4), pages 1127-1139, September.
    27. Jing-Zhi Huang & Ming Huang, 2012. "How Much of the Corporate-Treasury Yield Spread Is Due to Credit Risk?," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 2(2), pages 153-202.
    28. Jan Ericsson & Olivier Renault, 2006. "Liquidity and Credit Risk," Journal of Finance, American Finance Association, vol. 61(5), pages 2219-2250, October.
    29. Ulrich Schüwer & Claudia Lambert & Felix Noth, 2019. "How Do Banks React to Catastrophic Events? Evidence from Hurricane Katrina," Review of Finance, European Finance Association, vol. 23(1), pages 75-116.
    30. Kempf, Alexander & Korn, Olaf & Uhrig-Homburg, Marliese, 2012. "The term structure of illiquidity premia," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1381-1391.
    31. Jarrow, Robert A., 2010. "A simple robust model for Cat bond valuation," Finance Research Letters, Elsevier, vol. 7(2), pages 72-79, June.
    32. Black, Jeffrey R. & Stock, Duane & Yadav, Pradeep K., 2016. "The pricing of different dimensions of liquidity: Evidence from government guaranteed bonds," Journal of Banking & Finance, Elsevier, vol. 71(C), pages 119-132.
    33. Amy K. Edwards & Lawrence E. Harris & Michael S. Piwowar, 2007. "Corporate Bond Market Transaction Costs and Transparency," Journal of Finance, American Finance Association, vol. 62(3), pages 1421-1451, June.
    34. Alexander Braun, 2016. "Pricing in the Primary Market for Cat Bonds: New Empirical Evidence," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 83(4), pages 811-847, December.
    35. Berg, Gunhild & Schrader, Jan, 2012. "Access to credit, natural disasters, and relationship lending," Journal of Financial Intermediation, Elsevier, vol. 21(4), pages 549-568.
    36. Lesmond, David A & Ogden, Joseph P & Trzcinka, Charles A, 1999. "A New Estimate of Transaction Costs," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 1113-1141.
    37. Schuster, Philipp & Uhrig-Homburg, Marliese, 2015. "Limits to arbitrage and the term structure of bond illiquidity premiums," Journal of Banking & Finance, Elsevier, vol. 57(C), pages 143-159.
    38. Eldor, Rafi & Hauser, Shmuel & Pilo, Batia & Shurki, Itzik, 2006. "The contribution of market makers to liquidity and efficiency of options trading in electronic markets," Journal of Banking & Finance, Elsevier, vol. 30(7), pages 2025-2040, July.
    39. Lane, Morton & Mahul, Olivier, 2008. "Catastrophe risk pricing : an empirical analysis," Policy Research Working Paper Series 4765, The World Bank.
    40. Peter Feldhütter & Stephen M Schaefer, 2018. "The Myth of the Credit Spread Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 31(8), pages 2897-2942.
    41. Lin, Hai & Wang, Junbo & Wu, Chunchi, 2011. "Liquidity risk and expected corporate bond returns," Journal of Financial Economics, Elsevier, vol. 99(3), pages 628-650, March.
    42. Jack Bao & Jun Pan & Jiang Wang, 2011. "The Illiquidity of Corporate Bonds," Journal of Finance, American Finance Association, vol. 66(3), pages 911-946, June.
    43. Goldstein, Michael A. & Hotchkiss, Edith S., 2020. "Providing liquidity in an illiquid market: Dealer behavior in US corporate bonds," Journal of Financial Economics, Elsevier, vol. 135(1), pages 16-40.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Sukono & Herlina Napitupulu & Riaman & Riza Andrian Ibrahim & Muhamad Deni Johansyah & Rizki Apriva Hidayana, 2023. "A Regional Catastrophe Bond Pricing Model and Its Application in Indonesia’s Provinces," Mathematics, MDPI, vol. 11(18), pages 1-20, September.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Goldstein, Michael A. & Namin, Elmira Shekari, 2023. "Corporate bond liquidity and yield spreads: A review," Research in International Business and Finance, Elsevier, vol. 65(C).
    2. Díaz, Antonio & Escribano, Ana, 2022. "Liquidity dimensions in the U.S. corporate bond market," International Review of Economics & Finance, Elsevier, vol. 80(C), pages 1163-1179.
    3. Xuanjuan Chen & Jing-Zhi Huang & Zhenzhen Sun & Tong Yao & Tong Yu, 2020. "Liquidity Premium in the Eye of the Beholder: An Analysis of the Clientele Effect in the Corporate Bond Market," Management Science, INFORMS, vol. 66(2), pages 932-957, February.
    4. Song Han & Hao Zhou, 2016. "Effects of Liquidity on the Non-Default Component of Corporate Yield Spreads: Evidence from Intraday Transactions Data," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 6(03), pages 1-49, September.
    5. Díaz, Antonio & Escribano, Ana, 2020. "Measuring the multi-faceted dimension of liquidity in financial markets: A literature review," Research in International Business and Finance, Elsevier, vol. 51(C).
    6. Leal, Diego & Stanhouse, Bryan & Stock, Duane, 2020. "Estimating the term structure of corporate bond liquidity premiums: An analysis of default free bank bonds," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 67(C).
    7. Helwege, Jean & Wang, Liying, 2021. "Liquidity and price pressure in the corporate bond market: evidence from mega-bonds," Journal of Financial Intermediation, Elsevier, vol. 48(C).
    8. Stephanie Heck, 2022. "Corporate bond yields and returns: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 36(2), pages 179-201, June.
    9. Anténor-Habazac, Cassandre & Dionne, Georges & Guesmi, Sahar, 2018. "Cyclical variations in liquidity risk of corporate bonds," Working Papers 18-3, HEC Montreal, Canada Research Chair in Risk Management.
    10. Helwege, Jean & Huang, Jing-Zhi & Wang, Yuan, 2014. "Liquidity effects in corporate bond spreads," Journal of Banking & Finance, Elsevier, vol. 45(C), pages 105-116.
    11. Díaz, Antonio & Escribano, Ana, 2017. "Liquidity measures throughout the lifetime of the U.S. Treasury bond," Journal of Financial Markets, Elsevier, vol. 33(C), pages 42-74.
    12. Abudy, Menachem Meni & Raviv, Alon, 2016. "How much can illiquidity affect corporate debt yield spread?," Journal of Financial Stability, Elsevier, vol. 25(C), pages 58-69.
    13. Samir Kadiric & Arthur Korus, 2019. "The effects of Brexit on credit spreads: Evidence from UK and Eurozone corporate bond markets," International Economics and Economic Policy, Springer, vol. 16(1), pages 65-102, March.
    14. Javadi, Siamak & Mollagholamali, Mohsen, 2018. "Debt market illiquidity and correlated default risk," Finance Research Letters, Elsevier, vol. 26(C), pages 266-273.
    15. Fecht, Falko & Füss, Roland & Rindler, Philipp B., 2014. "Corporate Transparency and Bond Liquidity," Working Papers on Finance 1404, University of St. Gallen, School of Finance.
    16. Hatem Ben-Ameur & Tarek Fakhfakh & Alexandre Roch, 2024. "Valuing Corporate Securities When the Firm’s Assets are Illiquid," Computational Economics, Springer;Society for Computational Economics, vol. 63(2), pages 579-598, February.
    17. Samir Kadiric & Arthur Korus, 2018. "Effects of Brexit on Corporate Yield Spreads: Evidence from UK and Eurozone Corporate Bond Markets," EIIW Discussion paper disbei251, Universitätsbibliothek Wuppertal, University Library.
    18. Kim, Gi H. & Li, Haitao & Zhang, Weina, 2016. "CDS-bond basis and bond return predictability," Journal of Empirical Finance, Elsevier, vol. 38(PA), pages 307-337.
    19. Allaudeen Hameed & Jean Helwege & Ran Li & Frank Packer, 2019. "Measuring corporate bond liquidity in emerging market economies: price- vs quantity-based measures," BIS Papers chapters, in: Bank for International Settlements (ed.), Asia-Pacific fixed income markets: evolving structure, participation and pricing, volume 102, pages 45-62, Bank for International Settlements.
    20. Bethke, Sebastian & Gehde-Trapp, Monika & Kempf, Alexander, 2017. "Investor sentiment, flight-to-quality, and corporate bond comovement," Journal of Banking & Finance, Elsevier, vol. 82(C), pages 112-132.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bla:jrinsu:v:90:y:2023:i:2:p:283-328. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Wiley Content Delivery (email available below). General contact details of provider: https://edirc.repec.org/data/ariaaea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.