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CAT Bond Spreads Via HARA Utility and Nonparametric Tests

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  • Denis-Alexandre Trottier
  • Van Son Lai
  • Anne-Sophie Charest

Abstract

Previous empirical studies on catastrophe (CAT) bond premiums rely mostly on actuarial models, and usually compare their accuracy in terms of in-sample fit and out-of-sample predictive power. After deriving a utility-based specification for pricing CAT bonds under Hyperbolic Absolute Risk Aversion (HARA), we propose two specification tests that use nonparametric estimation techniques to test simultaneously for all possible mis-specifications. Existing pricing models with our new one are then estimated and tested with data from the primary market for CAT bonds. Our results suggest that the utility-based model we propose not only is well-suited for explaining the risk-return relationship observed in the CAT bond market but also delivers the best performance among the tested models. We also provide new empirical evidence that the aggregate utility function of CAT investors exhibits decreasing absolute risk aversion.

Suggested Citation

  • Denis-Alexandre Trottier & Van Son Lai & Anne-Sophie Charest, 2017. "CAT Bond Spreads Via HARA Utility and Nonparametric Tests," Working Papers 2017-002, Department of Research, Ipag Business School.
    • Handle: RePEc:ipg:wpaper:2017-002
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