economic catastrophe bonds - stanford university.pdf

Economic Catastrophe Bonds Joshua D. Coval, Jakub W. Jurek, and Erik Sta§ord Abstract The central insight of asset pricing is that a securityís value depends on both its distribution of payo§s across economic states and state prices. In Öxed income markets, many investors focus exclusively on estimates of expected payo§s, such as credit ratings, without considering the state of the economy in which default occurs. Such investors are likely to be attracted to securities whose payo§s resemble economic catastrophe bondsñbonds that default only under severe economic conditions. We show that many structured Önance instruments can be charac- terized as economic catastrophe bonds, but o§er far less compensation than alternatives with comparable payo§ proÖles. First draft: March 2007 This draft: October 2008 Coval: Harvard Business School; jcoval@ . Jurek: Bendheim Center for Finance, Princeton University; jjurek@ . Sta§ord: Harvard Business School; esta§ord@. We thank John Campbell, Mikhail Chernov, John Cochrane, Pierre Collin-Dufresne, Francis Longsta§, Bob Merton, AndrÈ Perold, Chester Spatt, and Jeremy Stein for valuable comments and discussions, and seminar participants at Boston College, Boston University, Georgia State University, Harvard Management Company, Harvard University, Ohio State University, Princeton University, MIT, NYU, University of Chicago, University of Pennsylvania, Virginia Tech, Yale University, the 2007 NBER Asset Pricing Summer Institute, the 2007 UNC/Duke Asset Pricing Conference, the 2008 Utah Winter F