Skip to Main Content
HBS Home
  • About
  • Academic Programs
  • Alumni
  • Faculty & Research
  • Baker Library
  • Giving
  • Harvard Business Review
  • Initiatives
  • News
  • Recruit
  • Map / Directions
Working Knowledge
Business Research for Business Leaders
  • Browse All Articles
  • Popular Articles
  • Cold Call Podcast
  • Managing the Future of Work Podcast
  • About Us
  • Book
  • Leadership
  • Marketing
  • Finance
  • Management
  • Entrepreneurship
  • All Topics...
  • Topics
    • COVID-19
    • Entrepreneurship
    • Finance
    • Gender
    • Globalization
    • Leadership
    • Management
    • Negotiation
    • Social Enterprise
    • Strategy
  • Sections
    • Book
    • Podcasts
    • HBS Case
    • In Practice
    • Lessons from the Classroom
    • Op-Ed
    • Research & Ideas
    • Research Event
    • Sharpening Your Skills
    • What Do You Think?
    • Working Paper Summaries
  • Browse All
    Economic Catastrophe Bonds
    13 Jul 2007Working Paper Summaries

    Economic Catastrophe Bonds

    by Joshua D. Coval, Jakub W. Jurek and Erik Stafford
    Pooling economic assets into large portfolios and tranching them into sequential cash-flow claims has become a big business, generating record profits for both the Wall Street originators and the agencies that rate these securities. This paper by business economics doctoral student Jakub Jurek and HBS professors Joshua Coval and Erik Stafford investigates the pricing and risks of instruments created as a result of recent structured finance activities. It demonstrates that senior collateralized debt obligation (CDO) tranches have significantly different systematic risk exposures than their credit rating-matched, single-name counterparts, and should therefore command different risk premia. Key concepts include:
    • Investors in senior CDO tranches are grossly undercompensated for the highly systematic nature of the risks they bear. An investor willing to assume the economic risks inherent in senior CDO tranches can, with equivalent economic exposure, earn roughly 3 times more compensation by writing out-of-the-money put spreads on the market.
    • Credit rating agencies do not provide customers with adequate information for pricing. They are willing to certify senior CDO tranches as "safe" when, from an asset pricing perspective, they are quite the opposite.
    LinkedIn
    Email

    Author Abstract

    The central insight of asset pricing is that a security's value depends on both its distribution of payoffs across economic states and state prices. In fixed income markets, many investors focus exclusively on estimates of expected payoffs, such as credit ratings, without considering the state of the economy in which default is likely to occur. Such investors are likely to be attracted to securities whose payoffs resemble those of economic catastrophe bonds-bonds that default only under severe economic conditions. We show that many structured finance instruments can be characterized as economic catastrophe bonds, but offer far less compensation than alternatives with comparable payoff profiles. We argue that this difference arises from the willingness of rating agencies to certify structured products with a low default likelihood as "safe" and from a large supply of investors who view them as such. Download on the Social Science Research Network.

    Paper Information

    • Full Working Paper Text
    • Working Paper Publication Date: June 2007
    • HBS Working Paper Number: 07-102
    • Faculty Unit(s): Finance
      Trending
        • 13 Jun 2022
        • Research & Ideas

        Extroverts, Your Colleagues Wish You Would Just Shut Up and Listen

        • 11 Apr 2014
        • Working Paper Summaries

        Learning By Thinking: How Reflection Improves Performance

        • 18 Apr 2022
        • HBS Case

        Dick’s Sporting Goods Followed Its Conscience on Guns—and It Paid Off

        • 23 Jun 2022
        • Research & Ideas

        All Those Zoom Meetings May Boost Connection and Curb Loneliness

        • 28 Jun 2022
        • Book

        The Moral Enterprise: How Two Companies Profit with Purpose

    Joshua D. Coval
    Joshua D. Coval
    Jay O. Light Professor of Business Administration
    Contact
    Send an email
    → More Articles
    Erik Stafford
    Erik Stafford
    John A. Paulson Professor of Business Administration
    Contact
    Send an email
    → More Articles
    Find Related Articles
    • Finance
    • Financial Services

    Sign up for our weekly newsletter

    Interested in improving your business? Learn about fresh research and ideas from Harvard Business School faculty.
    ǁ
    Campus Map
    Harvard Business School Working Knowledge
    Baker Library | Bloomberg Center
    Soldiers Field
    Boston, MA 02163
    Email: Editor-in-Chief
    →Map & Directions
    →More Contact Information
    • Make a Gift
    • Site Map
    • Jobs
    • Harvard University
    • Trademarks
    • Policies
    • Accessibility
    • Digital Accessibility
    Copyright © President & Fellows of Harvard College