Cat Bond Spreads : A New Model with an Empirical Validation Using Nonparametric Tests

Previous empirical studies on catastrophe (CAT) bond premium calculations rely almost exclusively on actuarial models, and usually compare their accuracy strictly in terms of in-sample t and predictive power. We contribute to this literature by deriving a utility-based specification for pricing CAT bonds under Hyperbolic Absolute Risk Aversion (HARA), and by proposing two specification tests that use nonparametric estimation techniques to test simultaneously for all possible mis-specifications. Various pricing models are then estimated and tested with data from the primary market for CAT bonds. Our results suggest that the utility-based model we propose not only is well-suited for explaining the risk-return relationship observed in the CAT bond market but also delivers the best performance among the tested models. We also provide new empirical evidence that the aggregate utility function of CAT investors exhibits decreasing absolute risk aversion