Answer-first summary for fast verification
Answer: c) To investors, an advantage of the CAT bond is that yield will be higher will probably be higher than Acme’s regular bond
A CAT bond transfers catastrophe risk to investors. Because investors are taking on event risk that is largely unrelated to normal market risk, they typically demand a higher yield than on a comparable regular corporate bond. - **A** is incorrect because CAT bonds usually do **not** offer the issuer a lower yield than a regular bond; the investor must be compensated for the catastrophe risk. - **B** is incorrect because CAT bonds are commonly structured with collateral to reduce or eliminate counterparty credit risk. - **D** is incorrect because CAT bond risk is often largely uncorrelated with traditional financial assets, which can provide **diversification benefits** rather than poor ones. Therefore, the correct answer is **C**.
Author: Manit Arora
Ultimate access to all questions.
Question 21.4.3
Acme is a large, diversified insurance company with an AA+ rating and a complex capital structure owing to its size. This year Acme will issue two debt instruments. One is a regular corporate bond that pays a 6.0% per annum coupon. The other is a CAT (catastrophe) bond triggered by Florida hurricane event(s). Given Acme’s strong credit rating and financial cushion, the probability of a hurricane event is significantly greater than Acme’s default probability. Of course, a CAT bond has unique features that suggest the motivations, for the issuer (aka, Acme) and its investors, will differ from the motivations related to a regular bond. In regard to these motivations and the advantages/disadvantages of a CAT bond, which of the following statements is TRUE?
A
a) To the issuer (Acme), an advantage of the CAT bond is that it can be offered a lower yield (i.e., cost of capital) than Acme’s regular bond
B
b) To the issuer (Acme), a disadvantage of the CAT bond is the counterparty (risk) exposure to the investors who might default in the event the CAT bond is triggered
C
c) To investors, an advantage of the CAT bond is that yield will be higher will probably be higher than Acme’s regular bond
D
d) To investors, a disadvantage of the CAT bond is that its high idiosyncratic risk (aka, specific risk) will confer poor diversification benefits
No comments yet.