Designing catastrophic bonds for catastrophic risks in agriculture

Abstract

Purpose– The purpose of this paper is to outline a pricing formula for the valuation of catastrophic (CAT) bonds as applied to multiple trigger drought risks in Kenya.Design/methodology/approach– The valuation model is designed around the multiple triggers of the Mexican Catastrophe bonds, but the valuation model is based on Jarrow’s (2010) closed form CAT Bond Pricing model. The authors outline the model structure, the multiple tranches with rainfall triggers, and simulate the model using Monte Carlo methods. Data input was synthesized from historical rainfall data in Kenya’s Moyale region as well as prevailing LIBOR and rates and conventional coupons.Findings– The authors compute the valuation model using Monte Carlo techniques. The authors found the pricing method to be robust and consistent under various parameter settings including trigger levels, time after launch, recovery rates, coupon spreads, and zero coupon curves. For example the higher the trigger rates, the lower will be the bond price at issue. With 50 percent recovery the CAT bond at issue would be around $702 with a high triggers and 976 with low triggers, but the valuation changes with parameters.Practical implications– As far as the authors know the use of multiple trigger CAT bonds has been very limited in practice. The valuation formula and methods outlined in this paper show how CAT bonds can be effectively designed to address CAT covariate risks in developing agricultural economies.Originality/value– This paper examines CAT bonds to investigate multi-trigger rainfall risks in Kenya. The paper shows how CAT bonds can be designed to meet specific and CAT risks. Using Jarrow’s (2010) closed form solution this paper is one of the first to apply it to the macro-management of agricultural risks.