IDEAS home Printed from https://ideas.repec.org/a/eee/corfin/v62y2020ics092911991930937x.html
   My bibliography  Save this article

Hard markets, hard times: On the inefficiency of the CAT bond market

Author

Listed:
  • Götze, Tobias
  • Gürtler, Marc

Abstract

This study explores the existence of inefficiencies in catastrophe (CAT) bond secondary markets by investigating the impact of sponsor characteristics on the CAT bond premium. We show that the CAT bond market does not satisfy the demand for catastrophe risk transfer efficiently by revealing a significant effect of sponsor-related factors on the CAT bond premium. This inefficiency is particularly surprising given that a CAT bond isolates the insured risk from other sponsor-related risks through a special purpose vehicle. Remarkably, this inefficiency is even present among non-indemnity CAT bonds, which determine the payout through a mechanism that is exogenous to the sponsor. Our findings also reveal that sponsor-related pricing inefficiencies vary over time and are more relevant during hard and neutral phases compared to soft market phases. Among the sponsor-related determinants of the CAT bond premium are the sponsor's tenure, market coverage, rating, credit default swap spread, and his ability to issue innovative “on the run” CAT bonds.

Suggested Citation

  • Götze, Tobias & Gürtler, Marc, 2020. "Hard markets, hard times: On the inefficiency of the CAT bond market," Journal of Corporate Finance, Elsevier, vol. 62(C).
    • Handle: RePEc:eee:corfin:v:62:y:2020:i:c:s092911991930937x
    DOI: 10.1016/j.jcorpfin.2019.101553
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S092911991930937X
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jcorpfin.2019.101553?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
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Stulz, René M., 1984. "Optimal Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(2), pages 127-140, June.
    2. Elayan, Fayez A & Maris, Brian A & Young, Philip J, 1996. "The Effect of Commercial Paper Rating Changes and Credit-Watch Placement on Common Stock Prices," The Financial Review, Eastern Finance Association, vol. 31(1), pages 149-167, February.
    3. 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.
    4. Patrick Bolton & Hui Chen & Neng Wang, 2011. "A Unified Theory of Tobin's q, Corporate Investment, Financing, and Risk Management," Journal of Finance, American Finance Association, vol. 66(5), pages 1545-1578, October.
    5. James W. Wansley & Terrence M. Clauretie, 1985. "The Impact Of Creditwatch Placement On Equity Returns And Bond Prices," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 8(1), pages 31-42, March.
    6. Grace, M. F. & J. L. Hotchkiss, 1993. "External Impacts on the Property-Liability Insurance Cycle," Working Papers 020, Risk and Insurance Archive, revised Feb 1995.
    7. Bjoern Hagendorff & Jens Hagendorff & Kevin Keasey, 2013. "The Shareholder Wealth Effects of Insurance Securitization: Preliminary Evidence from the Catastrophe Bond Market," Journal of Financial Services Research, Springer;Western Finance Association, vol. 44(3), pages 281-301, December.
    8. Papachristou, Dimitris, 2011. "Statistiscal Analysis of the Spreads of Catastrophe Bonds at the Time of Issue," ASTIN Bulletin, Cambridge University Press, vol. 41(1), pages 251-277, May.
    9. 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.
    10. Lane, Morton & Mahul, Olivier, 2008. "Catastrophe risk pricing : an empirical analysis," Policy Research Working Paper Series 4765, The World Bank.
    11. Michael S. Canter & Joseph B. Cole & Richard L. Sandor, 1997. "Insurance Derivatives: A New Asset Class for the Capital Markets and a New Hedging Tool for the Insurance Industry," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(3), pages 69-81, September.
    12. Gürtler, Marc & Neelmeier, Philipp, 2018. "Empirical analysis of the international public covered bond market," Journal of Empirical Finance, Elsevier, vol. 46(C), pages 163-181.
    13. Doherty, Neil A. & Kang, Han Bin, 1988. "Interest rates and insurance price cycles," Journal of Banking & Finance, Elsevier, vol. 12(2), pages 199-214, June.
    14. J. David Cummins & Mary A. Weiss, 2009. "Convergence of Insurance and Financial Markets: Hybrid and Securitized Risk‐Transfer Solutions," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 76(3), pages 493-545, September.
    15. Benjamin Yibin Zhang & Hao Zhou & Haibin Zhu, 2009. "Explaining Credit Default Swap Spreads with the Equity Volatility and Jump Risks of Individual Firms," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 5099-5131, December.
    16. Winter Ralph A., 1994. "The Dynamics of Competitive Insurance Markets," Journal of Financial Intermediation, Elsevier, vol. 3(4), pages 379-415, September.
    17. 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.
    18. John R. Graham & Daniel A. Rogers, 2002. "Do Firms Hedge in Response to Tax Incentives?," Journal of Finance, American Finance Association, vol. 57(2), pages 815-839, April.
    19. Howard Chan & Robert Faff & Paula Hill & Harald Scheule, 2011. "Are Watch Procedures A Critical Informational Event In The Credit Ratings Process? An Empirical Investigation," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 34(4), pages 617-640, December.
    20. Hansen, Bruce E., 1999. "Threshold effects in non-dynamic panels: Estimation, testing, and inference," Journal of Econometrics, Elsevier, vol. 93(2), pages 345-368, December.
    21. Kraft, Pepa & Xie, Yuan & Zhou, Ling, 2020. "The intraday timing of rating changes," Journal of Corporate Finance, Elsevier, vol. 60(C).
    22. Wu, Yang-Che & Chung, San-Lin, 2010. "Catastrophe risk management with counterparty risk using alternative instruments," Insurance: Mathematics and Economics, Elsevier, vol. 47(2), pages 234-245, October.
    23. Warga, Arthur, 1992. "Bond Returns, Liquidity, and Missing Data," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(4), pages 605-617, December.
    24. Bannier, Christina E. & Hirsch, Christian W., 2010. "The economic function of credit rating agencies - What does the watchlist tell us?," Journal of Banking & Finance, Elsevier, vol. 34(12), pages 3037-3049, December.
    25. Neil A. Doherty, 1997. "Financial Innovation in the Management of Catastrophe Risk," Center for Financial Institutions Working Papers 98-12, Wharton School Center for Financial Institutions, University of Pennsylvania.
    26. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. "Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-1658, December.
    27. Houweling, Patrick & Mentink, Albert & Vorst, Ton, 2005. "Comparing possible proxies of corporate bond liquidity," Journal of Banking & Finance, Elsevier, vol. 29(6), pages 1331-1358, June.
    28. Neil A. Doherty, 1997. "Financial Innovation in the Management of Catastrophe Risk," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(3), pages 84-95, September.
    29. Simon Gilchrist & Egon Zakrajsek, 2012. "Credit Spreads and Business Cycle Fluctuations," American Economic Review, American Economic Association, vol. 102(4), pages 1692-1720, June.
    30. Froot, Kenneth A., 2001. "The market for catastrophe risk: a clinical examination," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 529-571, May.
    31. Nance, Deana R & Smith, Clifford W, Jr & Smithson, Charles W, 1993. "On the Determinants of Corporate Hedging," Journal of Finance, American Finance Association, vol. 48(1), pages 267-284, March.
    32. Oliver Faltin-Traeger & Kathleen W. Johnson & Christopher Mayer, 2010. "Issuer Credit Quality and the Price of Asset Backed Securities," American Economic Review, American Economic Association, vol. 100(2), pages 501-505, May.
    33. Hand, John R M & Holthausen, Robert W & Leftwich, Richard W, 1992. "The Effect of Bond Rating Agency Announcements on Bond and Stock Prices," Journal of Finance, American Finance Association, vol. 47(2), pages 733-752, June.
    34. Alex Cowley & J. David Cummins, 2005. "Securitization of Life Insurance Assets and Liabilities," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 72(2), pages 193-226, June.
    35. Holthausen, Robert W. & Leftwich, Richard W., 1986. "The effect of bond rating changes on common stock prices," Journal of Financial Economics, Elsevier, vol. 17(1), pages 57-89, September.
    36. Norden, Lars & Weber, Martin, 2004. "Informational efficiency of credit default swap and stock markets: The impact of credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2813-2843, November.
    37. Ejsing, Jacob & Lemke, Wolfgang, 2009. "The Janus-headed salvation: sovereign and bank credit risk premia during 2008-09," Working Paper Series 1127, European Central Bank.
    38. Ilia D. Dichev & Joseph D. Piotroski, 2001. "The Long‐Run Stock Returns Following Bond Ratings Changes," Journal of Finance, American Finance Association, vol. 56(1), pages 173-203, February.
    39. John Griffin & Richard Lowery & Alessio Saretto, 2014. "Complex Securities and Underwriter Reputation: Do Reputable Underwriters Produce Better Securities?," Review of Financial Studies, Society for Financial Studies, vol. 27(10), pages 2872-2925.
    40. Tomasz Piskorski & Amit Seru & James Witkin, 2015. "Asset Quality Misrepresentation by Financial Intermediaries: Evidence from the RMBS Market," Journal of Finance, American Finance Association, vol. 70(6), pages 2635-2678, December.
    41. 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.
    42. Ejsing, Jacob & Lemke, Wolfgang, 2011. "The Janus-headed salvation: Sovereign and bank credit risk premia during 2008-2009," Economics Letters, Elsevier, vol. 110(1), pages 28-31, January.
    43. Froot, Kenneth A. & O'Connell, Paul G.J., 2008. "On the pricing of intermediated risks: Theory and application to catastrophe reinsurance," Journal of Banking & Finance, Elsevier, vol. 32(1), pages 69-85, January.
    44. Hagendorff, Bjoern & Hagendorff, Jens & Keasey, Kevin & Gonzalez, Angelica, 2014. "The risk implications of insurance securitization: The case of catastrophe bonds," Journal of Corporate Finance, Elsevier, vol. 25(C), pages 387-402.
    45. G. David Haushalter, 2000. "Financing Policy, Basis Risk, and Corporate Hedging: Evidence from Oil and Gas Producers," Journal of Finance, American Finance Association, vol. 55(1), pages 107-152, February.
    46. Stephan Dieckmann & Thomas Plank, 2012. "Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis," Review of Finance, European Finance Association, vol. 16(4), pages 903-934.
    47. Smith, Clifford W. & Stulz, René M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(4), pages 391-405, December.
    48. Niehaus, Greg, 2002. "The allocation of catastrophe risk," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 585-596, March.
    49. John M. Griffin & Gonzalo Maturana, 2016. "Editor's Choice Who Facilitated Misreporting in Securitized Loans?," Review of Financial Studies, Society for Financial Studies, vol. 29(2), pages 384-419.
    Full references (including those not matched with items on IDEAS)

    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. Götze, Tobias & Gürtler, Marc, 2020. "Risk transfer and moral hazard: An examination on the market for insurance-linked securities," Journal of Economic Behavior & Organization, Elsevier, vol. 180(C), pages 758-777.
    2. Dionne, Georges & Harrington, Scott, 2017. "Insurance and Insurance Markets," Working Papers 17-2, HEC Montreal, Canada Research Chair in Risk Management.
    3. Chatoro, Marian & Mitra, Sovan & Pantelous, Athanasios A. & Shao, Jia, 2023. "Catastrophe bond pricing in the primary market: The issuer effect and pricing factors," International Review of Financial Analysis, Elsevier, vol. 85(C).
    4. Tobias Götze & Marc Gürtler, 2022. "Risk transfer beyond reinsurance: the added value of CAT bonds," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 47(1), pages 125-171, January.
    5. Florian Kiesel & Sascha Kolaric, 2018. "Measuring the effect of watch-preceded and direct rating changes: a note on credit markets," Review of Quantitative Finance and Accounting, Springer, vol. 50(2), pages 653-672, February.
    6. Zhao, Yang & Yu, Min-Teh, 2020. "Predicting catastrophe risk: Evidence from catastrophe bond markets," Journal of Banking & Finance, Elsevier, vol. 121(C).
    7. Bjoern Hagendorff & Jens Hagendorff & Kevin Keasey, 2013. "The Shareholder Wealth Effects of Insurance Securitization: Preliminary Evidence from the Catastrophe Bond Market," Journal of Financial Services Research, Springer;Western Finance Association, vol. 44(3), pages 281-301, December.
    8. Peter Carayannopoulos & Olga Kanj & M. Fabricio Perez, 2022. "Pricing dynamics in the market for catastrophe bonds," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 47(1), pages 172-202, January.
    9. Yuriy Zabolotnyuk, 2018. "Wealth Effects of Bond Rating Announcements," Multinational Finance Journal, Multinational Finance Journal, vol. 22(3-4), pages 211-254, September.
    10. Kiesel, F. & Kolaric, S., 2018. "Measuring the effect of watch-preceded and direct rating changes: a note on credit markets," Publications of Darmstadt Technical University, Institute for Business Studies (BWL) 87386, Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute for Business Studies (BWL).
    11. Gibson, Rajna & Habib, Michel A. & Ziegler, Alexandre, 2014. "Reinsurance or securitization: The case of natural catastrophe risk," Journal of Mathematical Economics, Elsevier, vol. 53(C), pages 79-100.
    12. Mohamed Mnasri & Georges Dionne & Jean-Pierre Gueyie, 2013. "The Maturity Structure of Corporate Hedging: the Case of the U.S. Oil and Gas Industry," Cahiers de recherche 1337, CIRPEE.
    13. Söhnke M. Bartram & Gregory W. Brown & Frank R. Fehle, 2009. "International Evidence on Financial Derivatives Usage," Financial Management, Financial Management Association International, vol. 38(1), pages 185-206, March.
    14. Bartram, Söhnke M. & Brown, Gregory W. & Conrad, Jennifer, 2011. "The Effects of Derivatives on Firm Risk and Value," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(4), pages 967-999, August.
    15. Chen, Jun & King, Tao-Hsien Dolly, 2014. "Corporate hedging and the cost of debt," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 221-245.
    16. Lin, Yijia & Cox, Samuel H., 2008. "Securitization of catastrophe mortality risks," Insurance: Mathematics and Economics, Elsevier, vol. 42(2), pages 628-637, April.
    17. Ibañéz, Francisco & Romero-Meza, Rafael & Coronado-Ramírez, Semei & Venegas-Martínez, Francisco, 2016. "Innovaciones financieras en América Latina:Mercado de Derivados y Determinates de la Administración de Riesgo," Panorama Económico, Escuela Superior de Economía, Instituto Politécnico Nacional, vol. 0(22), pages 7-38, Primer se.
    18. Oberoi, Jaideep, 2018. "Interest rate risk management and the mix of fixed and floating rate debt," Journal of Banking & Finance, Elsevier, vol. 86(C), pages 70-86.
    19. Berghöfer, Britta & Lucey, Brian, 2014. "Fuel hedging, operational hedging and risk exposure — Evidence from the global airline industry," International Review of Financial Analysis, Elsevier, vol. 34(C), pages 124-139.
    20. Doukas, John A. & Mandal, Sonik, 2018. "CEO risk preferences and hedging decisions: A multiyear analysis," Journal of International Money and Finance, Elsevier, vol. 86(C), pages 131-153.

    More about this item

    Keywords

    CAT bond; Hard market; Market inefficiency; Risk premium; Sponsor;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

    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:eee:corfin:v:62:y:2020:i:c:s092911991930937x. 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: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jcorpfin .

    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.