Explanation:
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.
Therefore, the correct answer is C.
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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