Stephan Dieckmann

By Force of Nature: Explaining the Yield Spread on Catastrophe Bonds

This paper re-examines to which extent catastrophe bond prices can be explained via investor preferences. I show that cat bond spreads equal between two and three times expected losses after controlling for bond-specific characteristics. At the occurrence of Katrina, the model predicts a 15-20% increase in the cost of capital of reinsurance companies and plausible degrees of comovement among different perils. The driving force behind the model is a habit process, in that catastrophes are rare economic shocks that could bring investors closer to their subsistence level. Such preferences may also explain why catastrophe bonds offer higher yield spreads compared to equally-rated corporate bonds.

Rare Event Risk and Heterogeneous Beliefs: The Case of Incomplete Markets

This paper provides an equilibrium model subject to heterogeneous beliefs about the likelihood of rare events. I explore asset pricing implications in an incomplete capital market and the effects of market completion. Without explicit rare event insurance, investors insure themselves indirectly through the stock and money markets, the risk premium is countercyclical, and flight to quality effects arise. Upon market completion, the risk premium increases as investors increase their exposure to rare event risk. While market completion leads to a more efficient allocation based on investors’ anticipatory utilities, its effect on ex post efficiency is ambiguous.

Rare Event Risk and Emerging Market Debt with Heterogeneous Beliefs

In a setting where the lender and the borrower have heterogeneous beliefs about the likelihood of a disastrous shock to the borrowers economy, we study the debt contract that defaults at the occurrence of that shock, as proposed by Barro (2006). We find that a higher belief by the lender compared to the borrower can lead to countercyclical interest rates and credit spreads in non-default times, and to an increase in the borrowers indebtedness in default times, as often observed in emerging market economies. When calibrating the model to prices in the credit default swap market, we show that heterogeneous beliefs can account for more than 40% of the variation in CDS spreads associated with shocks to the borrowers economy in non-default times.

The Risk Sharing Implications of Disaster Insurance Funds

We study the risk sharing implications that arise from introducing a disaster relief fund to the cat insurance market. Such a form of intervention can increase efficiency in the private market, and our design of disaster relief suggests a prominent role of catastrophe reinsurance. The model predicts buyers to increase their demand in the private market, and the seller to lower prices to such an extent that her revenues decrease upon introduction of disaster relief. We test two predictions in the context of the Terrorism Risk Insurance Act (TRIA). It is already known the introduction of TRIA led to negative abnormal returns in the insurance industry. In addition, we show this negative effect is stronger for larger and for low risk-averse firms -- two results that are consistent with our model. The sellers risk aversion plays an important role in quantifying such feedback effects, and we point towards possible distortions in which a firm may even be overhedged upon introduction of disaster relief.

Exploring Common Factors in the Term Structure of Credit Spreads: The Use of Canonical Correlations

This paper provides a new approach to model the common variation in the term structure of credit spreads. The novelty is that common factors are extracted using canonical relations between credit spreads and observable economic variables. We show how these factors can be used to test if a given set of macroeconomic and financial variables is sufficient to capture all the systematic variation in response variables, such as credit spreads. We find that credit spread innovations are subject to three common factors, two strong factors and one weak factor, and they account for 49% of the total variation. The first strong factor is related to the contemporaneous state of the economy, the second represents expectations about future economic conditions, and the weak factor is mainly related to the error correction processes in short-term spreads.

The Announcement Effect of the EFSF

This paper documents the market reaction to the introduction of the European Financial Stability Facility (EFSF) in 2010 and 2011. The effect on borrowing rates is ambiguous - Greece, Ireland, Portugal, Spain, Italy and Slovenia exhibit a decrease in rates on event days, the remaining Eurozone countries exhibit an increase. The sovereign CDS market shows that not all of the effect on rates can be attributed to the assumption of default risk. CDS spreads do not increase in the case of Germany, France, the Netherlands, and Finland, consistent with a moderate increase in riskless rates. However, the net effect on the value of all Eurozone debt is positive and amounts to EUR 108 billion. Market participants also seem to anticipate an impact on real economic conditions given that the increase in non-financial equity value is EUR 126 billion, or 1.4% of Eurozone GDP.