Pricing Defaultable Catastrophe Bonds with Compound Doubly Stochastic Poisson Losses and Liquidity Risk

Catastrophe bond (CAT bond) is one of the modern financial instruments to transfer the risk of natural disasters to capital markets. In this project, we provide a structure of payoffs for a zero-coupon CAT bond in which the premature default of the issuer is also considered. The defaultable CAT bond price is computed by Monte Carlo simulations under the Vasicek interest rate model with losses generated from a compound doubly stochastic Poisson process. In the underlying Poisson process, the intensity of occurrence is assumed to follow a geometric Brownian motion. Moreover, the issuer’s daily total asset value is modelled by the approach proposed in Duan et al. (1995), and the liquidity process is incorporated to capture the additional return of investors. Finally, a sensitivity analysis is carried out to explore the effects of key parameters on the CAT bond price.