Unified Bayesian framework for pricing CAT bond derivatives

Catastrophe (CAT) bond markets are incomplete and hence carry uncertainty in instrument pricing. As such various pricing approaches have been proposed, but none treat the uncertainty in catastrophe occurrences and interest rates in a sufficiently flexible and statistically reliable way within a unifying asset pricing framework. Consequently, little is known empirically about the expected risk-premia of CAT bonds.

The primary contribution of this paper is to present a unified Bayesian CAT bond pricing framework based on uncertainty quantification of catastrophes and interest rates. Researchers present a framework that allows for complex beliefs about catastrophe risks to capture the distinct and common patterns in catastrophe occurrences, and when combined with stochastic interest rates, yields a unified asset pricing approach with informative expected risk premia. Specifically, using a modified collective risk model — Dirichlet Prior-Hierarchical Bayesian Collective Risk Model (DP-HBCRM) framework — researchers model catastrophe risk via a model-based clustering approach.

Interest rate risk is modeled as a Cox Ingersoll Ross (CIR) process under the Bayesian approach. As a consequence of casting CAT pricing models into the framework, researchers evaluate the price and expected risk premia of various CAT bond contracts corresponding to clustering of catastrophe risk profiles. Numerical experiments show how these clusters reveal how CAT bond prices and expected risk premia relate to claim frequency and loss severity.

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