PT  - JOURNAL ARTICLE
AU  - Adama Sanou
AU  - Issouf Soumaré
AU  - Claude Fluet
TI  - Optimal Choice between Cat Bond and Debt to Cover the Risks of Natural Disasters
AID  - 10.3905/jfi.2021.1.113
DP  - 2021 May 03
TA  - The Journal of Fixed Income
PG  - jfi.2021.1.113
4099  - https://pm-research.com/content/early/2021/05/03/jfi.2021.1.113.short
4100  - https://pm-research.com/content/early/2021/05/03/jfi.2021.1.113.full
AB  - This article analyses the choice between non-contingent bonds and catastrophe (CAT) bonds to cover the risk of earthquakes. A dynamic stochastic optimization model with frictions was developed and shows under which conditions it may be advantageous for a government to issue a CAT bond instead of a standard non-contingent bond. We show how friction costs, such as the illiquidity premium associated with non-contingent debt issuance when a catastrophe occurs, increase the opportunity to issue CAT bonds. The calibration of the proposed model to real data allows us to estimate the price of CAT bonds to insure against earthquake losses in Quebec.TOPICS: Fixed income and structured finance, tail risksKey Findings▪ This article proposes a dynamic stochastic optimization model with frictions to analyse the choice between non-contingent bonds and catastrophe (CAT) bonds to cover the risk of earthquakes.▪ Friction costs, such as the illiquidity premium associated with non-contingent debt issuance when a catastrophe occurs, increase the opportunity to issue CAT bonds.▪ The calibration of the proposed model to real data allows us to estimate the price of CAT bonds to insure against earthquake losses in Quebec.