How financial theory applies to catastrophe-linked derivatives - An empirical test of several pricing models.

This paper discusses the PCS Catastrophe Insurance Option Contracts, provid ing empirical support on the level of correspondence between real quotes an d standard financial theory. The highest possible precision is incorporated since the real quotes are perfectly synchronized and the bid-ask spread is always considered. A static setting is assumed and the main topics of arbi trage, hedging, and portfolio choice are involved in the analysis. Three si gnificant conclusions are reached. First, the catastrophe derivatives may o ften be priced by arbitrage methods, and the paper provides some examples o f practical strategies that were available in the market. Second, hedging a rguments also yield adequate criteria to price the derivatives, and some re al examples are provided as well. Third, in a variance aversion context man y agents could be interested in selling derivatives to invest the money in stocks and bonds. These strategies show a suitable level in the variance fo r any desired expected return. Furthermore, the methodology here applied se ems to be quite general and may be useful to price other derivative securit ies. Simple assumptions on the underlying asset behavior are the only requi red conditions.