2016-12-18 - By Meryem Savas

Cat bonds – correlation to traditional asset classes

One of the largest advantages of cat bonds is that they are fundamentally uncorrelated to other asset classes. A financial crisis does not trigger earthquakes. A deeper analysis also shows that large natural events do not affect broader markets, though they naturally have a large local impact.

As the value of cat bonds typically depend on specific predefined natural events, such as hurricanes and earthquakes, which are independent of the market, we find a low correlation between the Swiss Re Cat Bond Index and indices representing traditional asset classes, as found in the matrix below.

What is correlation?
Cat Bond Index Equity Index Bond Index Hedge Fund Index Japan Equity Index
Cat Bond Index 0.13 0.21 0.17 0.13
Equity Index 0.66 0.72 0.72
Bond Index 0.64 0.52
Hedge Fund Index 0.61
About the choice of indices

Do financial crises affect cat bonds?

That financial crises do not cause natural events and thus trigger cat bonds is self-evident. Instead, the possible effect is due to the possible effects on the instruments as such. To see how cat bonds react to different financial events, we look at the total return during selected periods with a negative effect on the financial market.

During the Asian crisis, throughout 2002, only the cat bond and hedge fund indices showed a positive return of 8.6% and 4.7%, respectively. In the same period, the returns of the two equity indices in the table showed a negative return of some -20% and the bond index returned -2.3%.

The Lehman Brother collapse during the 2008 financial crisis had, however, a negative impact on cat bonds, as the collateral of four cat bonds was invested in the bank. The nominal value of these bonds decreased and the index dropped -3.1% following the crash. The equity and bond indices fell in the same period about -30% and the hedge fund index dropped -18.2%.

Following these events, we saw structural changes to cat bonds in order to minimise the counter party credit risk. As a result of the Lehman crash, the collateral is now almost exclusively invested in government bonds with a high credit rating, minimising correlation to traditional asset classes.

During the European crisis in 2011, all indices but the Cat Bond Index showed negative returns. The Cat Bond Index returned 2.3% in the months concerned.

Return periods

Do natural catastrophes also trigger financial crises?

Though financial crises do not trigger natural catastrophes, there is, of course, a possibility that large natural events affect the economy. But an analysis shows marginal regional and global effects.

Not surprisingly, we see that cat bond indices temporarily drop following a catastrophe that triggers cat bonds.

In August 2005, hurricane Katrina became the costliest hurricane to date in the USA, with damages amounting to $125 billion. The hurricane triggered a cat bond and its effect on the cat bond market was

-1.9%. Besides the Cat Bond Index, also the American bond index delivered a negative result of -0.8%, while equity and hedge funds had positive returns. Katrina thus had no noticeable impact on the regional economy.

The earthquake and following tsunami in Tōhoku on March 11, 2011, had devastating effects, with damages exceeding $300 billion, corresponding to approximately 5% of the GDP of Japan. The earthquake contributed to the largest drop ever of the Cat Bond Index of -3.9%. The Japanese equity index dropped -7.3%. Meanwhile, the global equity index had, in the same period, a positive return of 2.7% and hedge funds had negative returns of -0.4%.

Hurricane Patricia, that made landfall on the Mexican coast in the autumn of 2015, triggered one cat bond at 50% and contributed to a small index loss of -0.2%. Other Indices showed positive figures and thus were not affected at all by Patricia.

Return Periods

Cat bonds are fundamentally uncorrelated with other asset classes

Which conclusions can we then draw from this analysis?

Financial crises do not cause natural catastrophes, and the correlation between cat bonds and traditional instruments is miniscule, which was demonstrated by the Asian and European crises. The 2008 financial crisis and the Lehman Brothers collapse, however, showed that bonds where the counterparty risks are not minimised could be affected by financial crises. After the 2008 financial crisis, this risk has been eliminated.

Hurricane Katrina had no significant impact on the American financial market. Historically, there are a number of hurricanes with severe local economic impact, but these hurricanes had low correlation to the larger regional economies.

The correlation between cat bonds and the Japanese equity index caused by the Tōhoku earthquake is obvious, as the economic impact on the country was severe. The impact on global indices was however negligible.

The analysis sheds light on the fundamentally uncorrelated nature of the asset class. Cat bonds have a very small correlation to traditional asset classes. We also see that financial events have had little impact on cat bonds, as can be expected as the underlying risks are completely different.

Furthermore, we see that the studied catastrophic events have not affected global indices, even though they have had a local effect, such as Tōhoku.

Print Friendly, PDF & Email

Share post:      
Meryem Savas

Meryem Savas

Underwriter

Meryem holds a Master of Science in applied physics and electrical engineering from Linköping University specializing in financial mathematics. At Entropics since August 2013.

View all posts from Meryem.