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Introduction
Catastrophe bonds (CAT bonds) are often said to be "zero-beta" investments.1 Their structure attempts to isolate investors from market-related risks and expose them only to event risk. As a result these securities are considered to be a valuable new source of diversification for investors. We examine this argument in the context of the 2008-2009 subprime financial crisis.
Research on CAT bonds has focused mainly on their pricing.2 In contrast, relatively little research has focused on the relation of CAT bonds with the rest of the market and the claim that they are zero-beta instruments. In this paper we investigate the correlation of CAT bond returns with other asset classes using a sample that includes pre- and post-crisis periods and a formal methodology that allows for time-varying correlations. In addition, we evaluate the effectiveness of CAT bonds as diversification instruments by estimating and analysing their dynamic hedge ratios 3 and comparing them with hedge ratios of other asset classes.
Our main findings are threefold. First, our results imply that CAT bonds were not zero-beta assets during the financial crisis. The dynamic correlation coefficients of CAT bonds with the market and the corresponding hedge ratios are statistically significant during the crisis. We argue that weaknesses associated with both the structure of CAT bond trust accounts and the composition of the assets used as collateral in the trust account are the main drivers of these results. Assets used as collateral in these trust accounts proved to be of lesser than expected quality and, furthermore, counterparties in swap agreements, put in place in an effort to immunise collateral asset returns from market fluctuations, were exposed to considerable credit risk or even defaulted during the crisis.
Second, we find evidence that the effects of the financial crisis on CAT bonds disappear by the beginning of 2011, as the correlations with the market returned to their statistically insignificant pre-crisis levels. These results may imply that the new and improved collateral structures created for CAT bonds issued after 2009 have been perceived as effective by market participants. These new structures attempt to enhance the credit quality of the collateral asset and include limits to the type of assets permitted in the collateral account, and constant monitoring and reporting...