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Catastrophe bonds premium puzzle of Behavioral Finance


Abstract: As a new financial tool,[link widoczny dla zalogowanych], since the catastrophe risk bonds from the issue of risks associated with the level of income to much higher than conventional bonds with the proceeds. Although the mean-variance method has been proved that This paper attempts to use behavioral finance theory to obtain a more reasonable explanation added. Investors by exploring the psychological, behavioral risk factors in the catastrophe bond premium puzzle in the important role played by, concluded: risk aversion, the fixed cost of education, fuzzy aversion and herd behavior such acts led to the emergence of premium puzzle . The discovery of these factors is not only the catastrophic risk to the international bond market to explain the high premium on an important basis for the phenomenon, but also for the issue of science provides a way catastrophe risk bonds. Keywords: Catastrophe risk bonds; premium puzzle; behavioral finance Abstract: As a new financial instrument, the risk premium of CAT bond has been much higher than that of traditional bonds with same credit rating since its issue. Although mean-variance analysis testified the existence of the CAT bond premium puzzle, the studies based on the classical theory cannot explain the cause for the high premium of CAT bond perfectly. The paper tries to resolve the puzzle successfully by using the behavioral finance theory. It discusses some psychological dynamics and behaviors of investors that play a key role in the premium puzzle of CAT bond. The result shows that risk-aversion, fixed cost of education, ambiguity aversion and herd effect cause the premium puzzle of CAT bond. This discovery not only provides a very important empirical foundation to explain the high premium of CAT bond in international CAT bond market, but also provides the clues to issuing CAT bond scientifically in China. Key words: the CAT bond; premium puzzle; behavioral finance is a catastrophe risk bond yields close contact with the huge disaster of the new financial investment instruments, it gives the Insurance after the accident in catastrophe against bankruptcy risks. Catastrophe bond issues since the high premium since 1997 there has been a successful issue. Domestic and foreign scholars on the causes of catastrophe bond premium and reasonable to do some research and feasibility studies. The traditional mean variance analysis method has been proved the existence of the mystery of a premium, but studies of traditional theory can not fully explain the causes of premium puzzle. Use Psychology and behavioral science and other knowledge, we find evidence of certain acts of investors to the issue of catastrophic risk premium bonds to add explanation to do better. One catastrophe risk bond According to Guy Carpnter & Company 1997-2006 finishing catastrophe risk bond transaction data, the risk of catastrophic risk bonds attached to than the London interbank offered rate yields the same level under the corporate bonds (BB level) higher nearly 200 basis points, and the gap in recent years, there is a tendency to increase. Single theoretical perspective, in the same price, catastrophe risk bonds should be compared with the level of the traditional high-yield bonds more attractive. Because of catastrophic risk bonds from financial markets with the characteristics of the internal fluctuations. Risks associated with the return it was only with the frequency and extent of the catastrophe linked to the financial markets there is no strong link. Therefore, the benefits of catastrophic risk bonds would yield than traditional bonds much more stable. Froot (1995) proved this advantage. Litzenberger, Beaglehole, and Reynolds (1996) study also showed that the catastrophe risk bond portfolio should be a useful tool for risk diversification. The face of catastrophic risk such a high premium on the bond market issues, Canabarro (1998) and others to the traditional mean - variance analysis (Mean-Variance Analysis) method, based on this research and analysis conducted. First,[link widoczny dla zalogowanych], set a simple binomial model, so that the same framework in a more traditional bonds and the value of catastrophic risk bonds. That total revenue for investors at this time are the principal (100) + risk-free rate of return at this stage (r) + commitment to the difference between the rate (s). Secondly, Canabarro, who will be the expected default rate is defined as E [R], compared with the corresponding variances var [R], then: E [V] = (1-p) (100 + r + s) + pE [R] var [V] = (1-p) {(100 + r + s)-E [V]} 2 + p {var [R] + (E [R]-E [V]) 2} by catastrophe risk in the high-yield corporate bonds and revenue bonds corresponding mean and variance, based on, Canabarro and others with the corresponding Sharpe ratio (Sharpe ratio) measures the relative value of each bond. The results showed that, even if the insurance company expected default rate is the highest Mosaic Class B, the Sharpe ratio (0.42) is higher than the Sharpe ratio Ba2 grade bonds (0.25). This shows that the yield of catastrophic risk bonds and other traditional bond equivalent rate of return, and on the Sharpe ratio, the catastrophe risk bonds look more attractive. This, one can not help but have a question, since the catastrophe risk bonds, higher security, and much higher income but also why investors were more interested in conventional bonds? The existing model does not explain why people are so risk-averse, why do they prefer to invest less in interest and market risks of the traditional bonds? Around the equity premium puzzle as to start the discussions, the catastrophe bond risk premium has also led to a series of controversial problems. Second, the catastrophe risk bond premium traditional interpretation of some studies that did not exist the so-called mystery, but when compared to select the reference problem. Other structures of the financial instruments (CBO, CLO, CMO, etc.) and emerging market bonds than the traditional high-yield bonds may be more suitable for comparison with the catastrophe risk bonds. Because these markets are larger price difference than LIBOR, investors will be required in the catastrophe bond market, spreads are similar to the larger value. However, it is clear that the current level, the loss is difficult to estimate the probability distribution, so the market mentioned earlier that the degree of risk aversion is not easily inferred. For example, as emerging market bonds have no default can be used to test the statistical probability distribution. Penalva-Zuasti (1997) that the catastrophe bond market in the high risk premium due to the novelty of catastrophe risk bond premiums (novelty premium) and the friction adjustment policies (regulatory frictions). Later Briys (1999) also made a series of cat bonds attractive point of view. Briys catastrophe bonds in the study pointed out that there is His research builds a pricing model to reflect these considerations. Indeed, in the actual financial market transactions, accept the just released news about changes in market conditions is a gradual process, and a major hurricane disaster early warning to the end from the total of the whole process may have only a few hours, no time advance warning. However, in the Securities price is defined as a function of time, the publishers have recognized that the high-yield corporate bond prices contain spread of part (Brownian motion, Brownian motion), and catastrophic risk bonds prices have substantially the characteristics of a sudden jump (jump process, jump process). It can be said that the catastrophe risk bond yields are not high time the issue has been fixed to be taken into account in pricing. View of this, simply use the traditional methods of research results to explain the formation of catastrophe risk bond premium is not enough. Numerous studies have been discovered the phenomenon of high-premium pricing theory and contrary to the traditional efficient market hypothesis, the academic community on the catastrophe risk bond market rationality and the rationality of people assume that traditional asset pricing theory, method of pricing catastrophe risk bonds questioned and turned to seek the interpretation of other areas. Third, behavioral finance catastrophe risk bond premium on the interpretation of explained in a number of catastrophe risk bond premium in the literature, from the perspective of behavioral finance is the core of the analysis. That, from the human psychology, behavioral science point of view of catastrophe bond market investors, behavioral characteristics, is to explain the phenomenon of mainstream premium. Vivek J. Bantwal, and Howard C. Kunreuther (2000) was the first to loss aversion, comparative neglect of behavioral finance theories such as catastrophic risk bond premium applied to the interpretation of the mystery, they used the model that investors in such securities preference uncertainty on the impact of bond prices. David Rode, Baruch Fischhoff, and Fischbeck (2000) discusses the potential catastrophic risk securitization obstacles, and focus on the people to face this new financial instrument to reflect on the act. Overall, the high catastrophe risk bond investors a premium is largely a result of irrational decisions, and its specific performance: (a) risk aversion (Risk Aversion) expectations based on the maximum investor risk aversion utility theory is often used to explain the behavior of asset pricing model to explain some of the weak. Whether the risk of catastrophe in the bond investment decision, investors will first consider the problem of how to avoid losses, followed by access to income, which is risk averse, it mainly includes two aspects: One Although the risk from the impact of the financial market system, the risk of catastrophic risk bonds yield is still of great uncertainty. For example, the traditional bond yields had been determined at the time of issue, investors earnings are predictable. Traditional bond issuer's credit income rate, credit rating agency's rating, the time of issuance in market interest rates and other factors. Under normal circumstances, as long as the maturity of the bond issuer to fulfill its obligations, the investor can not only recover the principal, the interest can be agreed. The catastrophe risk bond earnings are relatively more complex. Despite the catastrophe risk bonds when bond yields have agreed on the calculation of the standard, but the earnings of investors still uncertain. This is because the catastrophe risk bond investors, earnings depend on the particular catastrophe occurs or not, the loss of such a program. Therefore, the risk of catastrophe risk bond investors, bond investors than the traditional risk a large number. Maturity when the catastrophe does not occur if the agreement or does not meet the trigger conditions, they can often be higher than investment in conventional bond proceeds; but when a specific catastrophe losses of up to trigger events or conditions, then the investor will not only lose some or all of the interest, and may even lose some or all of the principal. Second, in the cat bond premium puzzle to explain attempts, Rode,[link widoczny dla zalogowanych], Fischhoff, and Fischbeck (1999) research indicates that risk aversion high returns. Previous studies had pointed out that investors have exaggerated the tendency of small probability events, that is a very small possibility of some people put too much attention to the incident, while ignoring any errors in their estimates. Catastrophic events are small in the statistical probability of the event, although the actual probability and consequences are not so bad as people think, can be investors or coincidentally on the catastrophe risk bonds have exclusion. Because they lost all of the principal amount of subconscious illusion will expand very large, investors may suffer a catastrophe such scruples to the terrible consequences of low probability event and give up potential access to potentially high returns. Taking into account the above two factors,[link widoczny dla zalogowanych], insurance companies, in order to increase the attractiveness of emerging bonds to provide risk-free interest rate relative to the high premium also makes sense initiatives. (B) the fixed cost of education (Fixed Cost of Education) Bantwal and Kunreuther (2000) pointed out that the risk of catastrophic risk bonds proceeds with the reason why more traditional risk-return investment instruments, mainly because of catastrophe risk debt capital markets for most of the investors is still a fairly new investment product. Most investors do not have this kind of product pricing, evaluation and risk analysis skills and knowledge required, so most of this new tool is also on the sidelines. Even investing in catastrophic risk bonds, also need to spend a certain amount of manpower, money and effort to understand the new market of legal and technical fine differences. The cost of this initial investment may exceed the beginning of catastrophe risk bonds from the proceeds received. Therefore, people may be afraid of more losses than gains while ignoring the advantages of catastrophic risk bonds, and thus avoid the risk of catastrophe bond investments. The issuing company to attract and encourage investors to bonds of this new ongoing and continuous investment in this market will give investors started his higher premium. Here, the investor can understand and evaluate the process of understanding of new securities for the issuer of such securities investment to help investors understand the process. Publishers for their premium is equivalent to reward the early investors the courage to try, or help investors familiar with the new market cost of education. Therefore,[link widoczny dla zalogowanych], we can also call premium If investors only in stocks or traditional bonds and evaluate the standards of catastrophic risk bonds, may ignore the catastrophic risk that some of the important features of bonds, or that there is some catastrophe risk bonds do not actually exist features. For example, a catastrophe risk bond investors will be seen as the traditional kind of fixed income financial instruments. The traditional bonds, if the investor until maturity proceeds less than face value, to show that the issuers of financial instruments in poor condition, can not fully repay the principal. The risk of catastrophe bonds, less than face value to repay the principal means of contract occurred within the specified disaster, catastrophe risk bond issuers, holders for the loss of shared responsibility for a portion of Peifu, this time issuing company Instead of the financial situation of the financial crisis does not appear, and even strengthened.
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