Diversification Benefits of Cat Bonds: An In-Depth Examination

Abstract

We investigate whether the inclusion of Cat Bonds in portfolios composed of traditional assets and common factors is beneficial to investors. Various mean‐variance spanning tests performed for the period of 2002 to 2017 show that under different market conditions, the addition of Cat Bonds gives rise to previously unattainable portfolios. Using the Engle (2002) Dynamic Conditional Correlation (DCC) model, we find that including Cat bonds increases significantly the time‐varying Sharpe ratio and the Choueifaty and Coignard (2008) maximum diversification ratio. Cat Bonds provide needed diversification during critical times particularly during episodes of crisis and of high volatility. Under the second‐order stochastic dominance efficiency (SDE) tests, the null hypothesis that portfolios without Cat Bonds are efficient cannot be rejected. Out‐of‐sample analyses indicate that the performance of portfolios with Cat Bonds included varies depending on the performance measures employed, the portfolio construction techniques used and the assets or factors considered.