Abstract
Catastrophe bonds are insurance linked securities that transfer catastrophe risks from the insurance industry to financial markets. These risks cannot be hedged with ordinary financial securities. Due to market incompleteness, arbitrage pricing methods generally do not yield uniquely determined bond prices. This paper presents an alternative pricing methodology in developing a simple equilibrium capital asset pricing model (CAPM) with incomplete markets in which the price of a catastrophe bond is determined by investors' risk preferences. Conditions under which catastrophe risks are transferred to the financial market are given and the effects of these transferred risks on equilibrium asset prices, risk allocations, and insurance premia are investigated.
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