Dependence structure of CAT bonds and portfolio diversification: a copula-GARCH approach

Abstract

This paper analyzes advantages of investing in catastrophe bonds (CATs) in terms of portfolio diversification. Indeed, the increase in environmental disasters and their economic and financial consequences are still poorly covered by insurance and reinsurance companies. As a result, there is a rapid growth in the use of catastrophe bonds on the financial markets, which can allow the transfer of risks to the capital market. We use copula-GARCH models to test the time-varying dependence of CATs, in a portfolio composed of six stock markets (CAC 40, DJIA, EUROSTOXX 50, FTSE 100, HANGSENG, and NIKKEI 225). Our results reveal that the CATs display the highest risk-adjusted performer. This security may be a good complement to a portfolio for investors seeking to optimize their risk-adjusted returns. In addition, the CATs are one of the best diversifiers. Finally, the CATs are the asset that increases the lowest the probability of extreme co-variations with its benchmark portfolio.