Disaster Bonds and Catastrophe Bonds - Term Paper Example

? Disaster Bonds/Catastrophe Bonds Introduction Economics is fundamentally described as an area of study that is mainly concerned with the creation, utilization and transfer of wealth. Correspondingly, the idea of macro economics is principally described as the branch of economics emphasizing on studying the approach of decision-making for the upliftment of an economy. This particular branch of economics focuses upon studying the entire financial system of an economy concerning total production as well as utilization, total investments and total savings (Tucker, 2010). With this concern, Disaster Bonds which are also acknowledged as catastrophe bonds or CAT bonds can be related to the aspect of macro economics. This is owing to the reason that these bonds are viewed to be risk-related securities which tends to uplift the position of an economy by raising huge amount of money during any sort of catastrophe such as the occurrence of floods, earthquakes and hurricanes among others (Coval, Jurek & Stafford, 2008). In this paper, a brief overview and a detailed explanation about this class of bonds, i.e. catastrophe bonds will be taken into concern. Moreover, the interrelation of these bonds with the conceptions of systematic (market) risk and idiosyncratic risk along with interest-rate risk will be considered. Various aspects that include the association of CAT bonds with the Theory of Asset Demand and comparison of these bonds with more common types of bonds and a comprehensive explanation about the advantages along with the disadvantages possessed by the aforementioned bonds will also be discussed in the paper. 1) Overview and Explanation of Disaster or Catastrophe (CAT) Bonds Disaster or Catastrophe (CAT) Bonds are usually regarded as high yield and risk-associated debt instruments or securities that are largely executed with the motive of raising money in the occurrence of catastrophes such as hurricanes, floods and earthquakes and other natural calamities. In general, these bonds can be typically characterized as high-yield debt appliances that are normally insurance-connected and are used to raise huge amount of money during the occurrence of any sort of catastrophe. It has been apparently observed in this context that these sort of bonds posses a special condition which represents that if a particular issuer i.e. an insurance or a reinsurance company experiences any loss from a specific catastrophe, the debt of the issuer concerning the payment of interest or the principal repayment figure is either totally overdue or completely forgiven (Coval, Jurek & Stafford, 2008). The prime intention of CAT bonds has been identified as transferring the risk caused by any kind of catastrophe particularly from the insurance industry towards capital markets. It has been viewed in this regard that these sorts of bonds are commonly used in various advanced nations with the intention of mitigating the issues or problems resulting from the occurrence of catastrophes. The CAT bonds became quite popular in certain business markets that comprise Europe, United States and Japan among others. However, in common instances, it has been the insurers who broadly execute theses bonds as a substitute towards reinsurance. It is in this context that the different insurance or reinsurance organizations issue these kinds of bonds and place them in front of different investors. This activity of the insurance or reinsurance organizations ultimately helps them towards transferring certain proportion of risks to those investors. In this regard, the various insurance or reinsurance companies can further endow a substantial proportion of their invested amount in any other financial sphere by selling CAT bonds. It is the government or the different financial institutions that possess the authority of issuing these bonds by a considerable extent (Coval, Jurek & Stafford, 2008). In order to analyze CAT bonds, it has been apparently observed that these bonds were initially introduced or issued in the midst of 1990s, during the repercussion of the Northridge earthquake and Hurricane Andrew. These catastrophes ultimately resulted in causing extreme financial pressures, leading several insurance companies towards default and deteriorating infrastructures. Thus, it can be stated that it is the insurance or reinsurance companies that suffered much due to the occurrence of the aforementioned catastrophes. In this regard, it has been viewed that the insurance market has developed over time due to the enlargement in the openings of insurance sector worldwide. Moreover, apart from the expansion of the insurance sector, the number of participants linked with insurance or reinsurance industry has also increased by a significant level in the current day context. Since its initial phase, the quantity of participants associated with the insurance or reinsurance industry has increased considerably by 44%, as compared to its recent performances. Thus, it can broadly be affirmed that with the rising quantity of participants in the insurance or reinsurance sector, the issuance as well as the sales of CAT bonds have also augmented extensively (The Economic Times, 2013). 2) Relation of Disaster or CAT Bonds to the Concepts of Systematic (Market) Risk, Idiosyncratic and Interest-Rate Risk The conception of systematic risk, which is also prevalently acknowledged as market risk is generally characterized in the form of an entire or a specific segment of business market. It is obvious with reference to the fact that as the business market is highly fluctuating, there always exists the chance of high risks. Contextually, the different sources of systematic or market risks can be identified as recession, price wars and rise as well as fall in the interest rates. These sources relating to systematic or market risks are expected to unfavorably affect the entire business market that cannot be solved by following the approach of diversification principally. The relation of CAT bonds to the conception of systematic or market risk can be determined on the basis of the increments obtained in the interest charges. In this similar context, it has been viewed that when the interest charges rise considerably, the values of the formerly issued bonds ultimately lessen at large. At this particular situation, the investors are keener towards purchasing CAT bonds because of their high rates supporting them to attain significant profits. Contextually, the notion of idiosyncratic risk typically signifies those particular risks that impose significant impacts upon the stock price and value of the insured assets. However, the idiosyncratic risk can be diminished by adopting and following the approaches of diversification. In order to determine the relation of CAT bonds with the concept of idiosyncratic risk, it can be apparently observed that natural catastrophes generally represent idiosyncratic risks. The insurance-associated securities like the CAT bonds are vitally issued to the investors with the motive of mitigating idiosyncratic risks that ultimately affects them in terms of devaluing stock prices and most importantly lessening value of the insured assets (Simoni, 2011). The perception of interest-rate risk determines that the value of an investment made by the investors would change owing to the reason of transformation in the absolute degree of interest charges. Moreover, this particular risk also determines that the market interest charges would rise substantially as compared to the interest charges that are earned on certain investments like bonds resulting in the overall reduction of the market value of the insured assets. The aspect of interest-rate risk has further been noted as one of the important components of systematic or market risk. After acquiring a brief idea about the notion of interest-rate risk, it can broadly be affirmed that this sort of risks can be related to CAT bonds at large which can further be justified with reference to the fact that the issuance of CAT bonds might transfer greater risks to the investors. Conversely, it has been apparently observed that the investors particularly desire to invest more upon CAT bonds with the intention of reaping the benefits of attaining higher charges of interests. In this regard, the investors strongly believe that they can be certainly facilitated with rising market share by investing substantially upon the CAT bonds (Simoni, 2011). Thus, on the basis of the above discussion, it can be stated that the CAT bonds are related to the conceptions of strategic (market), idiosyncratic and interest-rate risks in the current market scenario. 3) Relation of Disaster or CAT Bonds to the Theory of Asset Demand The Theory of Asset Demand has been viewed to be associated with the demand quantity of an asset. It signifies that the demanded quantity of a particular asset is deeply influenced by certain important factors. These factors are fundamentally determined with the perception that the demanded quantity of a specific asset is directly interconnected with wealth and is also positively linked to its expected returns. Moreover, the factors also hold the perception that the demanded quantity of a particular asset is pessimistically correlated with the risks associated with its returns. Furthermore, the demanded quantity of a definite asset is positively allied to its position of liquidity linked with alternative assets through CAT bonds. The major aspects of this theory generally comprise demand along with supply shifts. In this similar concern, the shift in the demand side of the industry usually occurs at the time when liquidity raises and risk associated with the transaction diminishes. Conversely, the shift in the supply side takes place when the profitability relating to the opportunities of capital investment increases and also at instances when the willingness of the local or the federal government increases towards spending up different capital projects (Bailey, 2005). After acquiring a brief idea about the Theory of Asset Demand, it can be affirmed that with reference to the fact that the CAT bonds are usually invested by different financial investors such as the insurance or reinsurance companies with the intention of creating superior returns on money market resulting in acquiring higher market share and raising substantial profits. As the demand along with supply shifts depend upon the amount invested in risk-free assets, it can broadly be affirmed that there exists a direct association between CAT bonds and the Theory of Asset Demand (Bailey, 2005). While acquiring a comprehensive and in-depth knowledge about the class or the type of CAT bonds, it has been apparently observed that it is the financial investors who purchase these sorts of bonds at large. In this similar context, the financial investors decide to purchase CAT brands with the motive of obtaining higher rate of returns. The investors decide to purchase CAT bonds due to its significant facets such as its rating and most significantly its freely tradable nature. Moreover, these bonds possess the capability towards enhancing risk-return profile belonging to an investment portfolio which further increases the advantages expected by the investors from this kind of bonds. Another important reason for the investors to buy extensive quantity of CAT bonds has been driven by the financial investors’ strong belief that they can attain higher interest charges by investing their money in the capital markets. Moreover, they also realized that by making considerable investments particularly in the form of buying CAT bonds, they can recoup a smaller proportion of losses resulting from any sort of catastrophe such as earthquake, flood or hurricane among others (Bloomsbury Information Ltd, 2010). The future predictions and forecasts conducted by market experts have revealed that the finance and banking industry would issue CAT bonds to different financial investors at a larger quantity in the near future. Hence, it can be affirmed that the insurance or reinsurance organizations or institutions might be benefitted from the issuance of these classes of bonds at a larger quantity. This can be owing to the reason that the insurance or reinsurance organizations would be able to alleviate critical problems or issues relating to finance at the time of any catastrophe occurrence. Moreover, they can be benefitted from the issuance of CAT bonds to the financial investors in terms of mitigating any sort of damage resulting from the occurrence of catastrophe through gaining substantial returns from their investments. It has been apparently observed in this similar context that the CAT bonds were firstly introduced in the capital markets during the mid 1990s. The insurance or reinsurance organizations generally issue these sorts of bonds through an investment bank which are then sold to the different financial investors in the capital market. It is worth mentioning in this regard that the frequent occurrences of catastrophes such as floods, earthquakes and hurricanes among others in different regions throughout the globe have ultimately urged the insurance or reinsurance organizations to issue CAT bonds to the financial investors with the motive of reaping the aforesaid benefits (The Economic Times, 2013). 4) Compare and Contrast of Catastrophe Bonds To Other Common Types of Bonds Apart from the CAT bonds, the other common sorts of bonds fundamentally comprise the Municipal Bonds, Mortgage Backed Securities, Corporate Bonds and U.S. Government Securities. One of the significant differences between these common kinds of bonds and CAT bonds is that the aforesaid bonds are closely associated with financial market conditions and stock markets; whereas, the CAT bonds are closely interconnected with the natural environmental conditions and uncontrollable risks of natural disasters such as flood, earthquake and storms among others. Moreover, another vital difference that has been viewed between the CAT bonds and the aforesaid common sorts of bonds is regarding the aspect of credit quality. In this regard, the credit quality of the CAT bonds has been noted to be quite superior in comparison with the other common kinds of bonds (Wells Fargo, 2013). After acquiring a brief idea about the type as well as the nature of CAT bonds, it can be apparently observed that these bonds posses numerous advantages along with disadvantages as compared to other bonds. In this similar concern, one of the important advantages of CAT bonds has been noted as its unique characteristic owing to which, these bonds can be termed as insurance securitization investments that yields greater rate of returns. Moreover, the advancement of these particular bonds has eventually forced the re-insurers towards becoming more competitive with pricing in the capital markets resulting in coping up with uncontrollable risks in terms of natural disasters. In addition, the deliverance or offerings of outstanding diversification opportunities, especially for bond portfolios is recognized to be the other chief advantage of CAT bonds. On the other hand, the accessibility of CAT bonds only to the financial or institutional investors can be identified as one of the crucial disadvantages of these classes of bond. Furthermore, the liquidity condition in the capital markets linked with CAT bonds is also regarded as the other critical disadvantage of these bonds. In this regard, it has been viewed that the CAT bonds typically suffer from lower liquidity level in the capital markets resulting in causing difficulties to the investors at large (Bloomsbury Information Ltd, 2010). Conclusion After acquiring a brief idea about the nature, facets and the advantages along with the disadvantages of CAT bonds, it can be affirmed that these classes of bonds can prove to be much beneficial for the different financial investors by a significant extent. As a matter of fact, the CAT bonds have been viewed to gain momentum after the happenings of different sorts of catastrophes such as floods and earthquakes among others. Notably, it is the financial or the institutional investors who buy these bonds in order to acquire higher rate of returns. Conversely, the insurance or the reinsurance companies have been viewed to be largely issuing these bonds, especially to the investors with the intention of mitigating the damages that result from the occurrence of any catastrophe. Thus, it can be concluded that there exists the prospect of CAT bonds to flourish more in the capital markets in future. References Bailey, R. E. (2005). The economics of financial markets. England: Cambridge University Press. Bloomsbury Information Ltd. (2010). Approaches to enterprise risk management. Britain: A & C Black. Coval, J. D., Jurek, J. W., & Stafford, E. (2008). Abstract. Economic Catastrophe Bonds, 1-35. Simoni, M. C. (2011). A decision model for real estate portfolio valuation and optimisation. Germany: Haupt Verlag AG. The Economic Times, (2013). News. Cat Bonds Yield Higher Returns. Tucker, I. B. (2010). Macroeconomics for today. United States: Cengage Learning. Wells Fargo. (2013). Types of Bonds. Investing. Read More