Portfolio Diversification Effects of Catastrophe Bonds

Abstract

This paper demonstrates that catastrophe (cat) bonds provide substantial benefits of diversification when added to an investor's opportunity set already consisting of securities from traditional asset classes. We find that cat bonds significantly reduce drawdown measures and tail risk under various market regimes while still enhancing risk-adjusted returns. We estimate DCC-GARCH models and find a low average correlation between cat bonds and traditional asset classes. We then conduct rigorous out-of-sample portfolio analysis using four different asset-allocation models of varying levels of estimation risk. This analysis shows superior performance compared to a dynamic and optimized benchmark portfolio. Finally, we conduct mean-variance spanning tests and provide further compelling evidence that portfolios including cat bonds lie outside of the mean-variance frontier attainable by portfolios holding traditional asset classes alone.