Definition: A (noncallable) Bullet Bond (q.v.), minus (i.e., short) a Call Option (q.v.) on the bond. The Call Price as a function of calendar time is the Call Schedule.
Example: The U.S. Treasury issued a long sequence of Callable Bonds, callable five years before maturity.
Application: A Callable Bond is a way to make a bet about refinancing costs at the Call Date. The issuer is betting that interest rates will drop, the bond price will rise, he will call the bond, and he will refinance at a lower rate. The bondholder takes the other side of that bet.
Pricing: The Callable Bond is equivalent to a portfolio, so its value should equal the value of the portfolio, namely, the value of the Bullet Bond minus the value of the Call Option.
Risk Management: An issuer could offset the short position in the Bond Option (q.v.) by buying a corresponding Receiver Swaption on a Swap with the same coupon as the Bond.
Comment: For a given coupon rate the Callable Bond will be worth less than the noncallable bond. Hence, for a given price (such as par) the Callable Bond will have a higher coupon rate.
Call Option
The right, but not the obligation to buy the underlying asset at the previously agreed-upon price on (European) or anytime through (American) the expiration date.
Catastrophe Bond
Definition: A Bond that promises a coupon (and principal, in some cases) that starts out high, but drops after a suitable catastrophe occurs. A suitable catastrophe might be an earthquake or hurricane of sufficient magnitude and within a particular region.
Catastrophe Bonds may be ABS's (q.v.). The underlying assets may include a pool of Treasury securities. The underlying income stream might be reinsurance premiums. The ABS issue may have two or more classes of securities.
Example: A recently proposed (as of 5/30/97) USAA, Inc. Catastrophe issue has a principal protected class (secured by Treasury Zero Strips) and a principal variable class that would become worthless after a hurricane did $1.5 billion of damage anywhere from Maine to Texas.
Application: The natural issuer of a Catastrophe Bond is an insurance company or a government agency such as the California Earthquake Authority – any organization exposed to claims resulting from the underlying catastrophe. The Catastrophe Bond is in theory and perhaps even in practice a highly efficient way of paying outside investors (i.e., outside the insurance industry, including the reinsurance market) to share the risk of the catastrophe with the vast general capital market. It is a simple extension of the time-honored concept of securitization.
Pricing: Equilibrium of supply and demand.
Risk Management: Traditional hedging is impossible. Diversification is possible.
Comments:
The holder of a Catastrophe Bond is short a Bet, Binary, or Digital Option (all of which q.v.). The Catastrophe Bond is an ideal instrument for an unscrupulous security salesman to present to unsuitably naive retail or even institutional customers, who lack any concept of that game's odds, or perhaps even its basic rules. Thus, it has excellent potential as a successor to the sometimes abusive or fraudulent sales of poorly understood Florida real estate, securitized receivables, mortgage-backed securities and derivatives, limited partnership interests in real estate and oil exploration, etc.
I predict confidently three things:
(1) Competent underwriters of Catastrophe Bonds will not play Russian roulette by holding large positions in them in their investment portfolios for long periods. They will distribute the bonds as soon as possible.
(2) Accordingly, almost all of these Catastrophe Bonds will end up in the portfolios of institutional investors, high-rolling individual investors, and retail customers – many of whom will have no idea what they're getting into.
(3) In at least one exceptional case, some manager of a Catastrophe Bond (or Derivatives) desk will convince his naive boss that "the market has badly underestimated the real value of certain Catastrophe Bonds (Derivatives), and we should take them into inventory, temporarily." At that point the chips are down and the outcome – "heroism" or disaster – is up to fate.
Comment: Scholars are praising cat bonds and other derivatives for attracting low-cost capital into the industry. (Robert Hunter, "Cat Fever," Derivatives Strategy, February 1998, p. 6.) However, it's not clear that society is better off if the newcomers are paying to much for claims based on catastrophic claims.
Catastrophe Futures
The ill-fated futures contract that the CBOT introduced in 1993. The underlying risk factor was the Property Claims Service (PCS) index, which was too broad an index for most natural hedgers to use. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
Catastrophe Options
The CBOT's option contracts on several regional indexes of losses. The option on the Eastern Catastrophic contract boomed as Hurricane Fran smashed the Carolinas in the fall of 1996. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
Catastrophe options come in two main varieties: (1) Property Claims Services (PCS) options pay out (European style) based on an index of all claims against property insurance companies. (2)Single-Cat options pay out (American or one-touch style) based on a single, large atmospheric or seismic disaster in a single region (northeast, southeast, east, midwest, or west) or in California, Texas, or Florida. ("A New Take on Cat Options," Derivatives Strategy, February 1998, pp. 5-6.)
Catastrophe Swaps
Contracts similar to standard reinsurance contracts and traded on New York's Catastrophe Exchange. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
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