# Catastrophe Bonds Fall as Hurricane Harvey Bears Down on Texas

Good article from Bloomberg on how catastrophe (AKA “cat”) bonds are a unique asset class for investors and how such bonds disrupt traditional reinsurance markets.  For a broader perspective of these topics, also see the August 2016 WSJ article entitled “The Insurance Industry Has Been Turned Upside Down by Catastrophe Bonds” and my blog posting entitled “Cat Bonds“.

Cat bonds represent a form of securitization in which risk is transferred to investors rather than insurers or reinsurers. Typically, an insurer or reinsurer will issue a cat bond to investors such as life insurers, hedge funds and pension funds. The bonds are structured similarly to traditional bonds, with an important exception: if a pre-specified event such as a hurricane occurs prior to the maturity of the bonds, then investors risk losing accrued interest and/or the principal value of the bonds. This is why these bonds are falling in price – investors expect that the payment triggers tied to storms like #Harvey will reduce the payments received by holders of these bonds.

Bonds tied to weather risks tumbled the most in seven months as Hurricane Harvey advances on Texas’s Gulf Coast.

# Place Your Bets: When Will the U.S. Hit the Debt Ceiling?

This is an excellent article on how asset prices impound political risks, and the role of so-called “prediction markets” in assessing political event probabilities (in this case, the likelihood of the U.S. defaulting on its debt).

Prediction markets add a crowdsourced opinion to the chaos of Washington.

# Plans for next week’s Finance 4335 class meetings, along with a preview of future topics

The next two class meetings will be devoted to covering various topics in probability and statistics that are important for Finance 4335. On Tuesday, August 29, class will begin with a quiz on the assigned readings (“The New Religion of Risk Management” and “Normal and standard normal distribution“). Furthermore, Problem Set 1 will be due at the beginning of class that day.

While I have your attention, let me briefly explain what the main “theme” will initially be in Finance 4335 (up to the first midterm exam, which is scheduled for Tuesday, September 26). Specifically, we will delve into decision theory. Decision theory addresses decision making under risk and uncertainty, and not surprisingly, risk management lies at the very heart of decision theory. Initially, we’ll focus our attention upon variance as our risk measure. Most basic finance models (e.g., portfolio theory and the capital asset pricing model, or CAPM) implicitly or explicitly assume that risk = variance. We’ll learn that while this is not necessarily an unreasonable assumption, circumstances can arise where it is not an appropriate assumption. Furthermore, since individuals and firms are typically exposed to multiple sources of risk, we need to take into consideration the portfolio effects of risk. To the extent to which risks are not perfectly positively correlated, this implies that risks often “manage” themselves by canceling each other out. Thus the risk of a portfolio is typically less than the sum of the individual risks which comprise the portfolio.

The decision theory provides us with a very useful framework for thinking about concepts such as risk aversion and risk tolerance. The calculus comes in handy by providing an analytic framework for determining how much risk to retain and how much risk to transfer to others. Such decisions occur regularly in daily life, encompassing practical problems such as deciding how to allocate assets in a 401-K or IRA account, determining the extent to which one insures health, life, and property risks, whether to work for a startup or an established business, and so forth. There’s also quite a bit of ambiguity when we make decisions without complete information, but this course will at least help you think critically about costs, benefits, and trade-offs related to decision-making whenever you encounter risk and uncertainty.

After the first midterm, we’ll move on to other topics including demand for insurance, asymmetric information, portfolio theory, capital market theory, option pricing theory, and corporate risk management.

# Insurance featured as one of “50 Things That Made the Modern Economy”

During the past year, Financial Times writer Tim Harford has presented an economic history documentary radio and podcast series called 50 Things That Made the Modern Economy.  While I recommend listening to the entire series of podcasts, I would like to call your attention to Mr. Harford’s episode on the topic of insurance, which I link below.   This 9-minute long podcast lays out the history of the development of the various institutions which exist today for the sharing and trading of risk, including markets for financial derivatives as well as for insurance. Here’s the description of this podcast:

“Legally and culturally, there’s a clear distinction between gambling and insurance. Economically, the difference is not so easy to see. Both the gambler and the insurer agree that money will change hands depending on what transpires in some unknowable future. Today the biggest insurance market of all – financial derivatives – blurs the line between insuring and gambling more than ever. Tim Harford tells the story of insurance; an idea as old as gambling but one which is fundamental to the way the modern economy works.”

Insurance is as old as gambling, but it’s fundamental to the way the modern economy works
bbc.co.uk

# On the relationship between the S&P 500 and the CBOE Volatility Index (VIX)

Besides going over the syllabus during the first day of class on Tuesday, August 22, we will also discuss a “real world” example of financial risk. Specifically, we will look at the relationship between short-term stock market volatility (as indicated by the CBOE Volatility Index (VIX)) and returns (as indicated by the SP500 stock market index).

As indicated by this graph from page 25 of next Tuesday’s lecture note, daily percentage changes on closing prices for VIX and the SP500 are strongly negatively correlated. In the graph above, the y-axis variable is the daily return on the SP500, whereas the x-axis variable is the daily return on the VIX. The blue points represent 6,959 daily observations on these two variables, spanning the time period from January 2, 1990 through August 11, 2017. When we fit a regression line through this scatter diagram, we obtain the following equation:

${R_{SP500}} = 0.0005 - 0.1198{R_{VIX}}$,

where ${R_{SP500}}$ corresponds to the daily return on the SP500 index and ${R_{VIX}}$ corresponds to the daily return on the VIX index. The slope of this line (-0.1198) indicates that on average, daily VIX returns during this time period were inversely related to the daily return on the SP500; i.e., when volatility as measured by VIX went down (up), then the stock market return as indicated by SP500 typically went up (down). Nearly half of the variation in the stock market return during this time period (specifically, 49.5%) can be statistically “explained” by changes in volatility, and the correlation between ${R_{SP500}}$ and ${R_{VIX}}$ comes out to -0.703. While a correlation of -0.703 does not imply that ${R_{SP500}}$ and ${R_{VIX}}$ will always move in opposite directions, it does indicate that this will be the case more often than not. Indeed, closing daily returns on ${R_{SP500}}$ and ${R_{VIX}}$ during this period moved inversely 78% of the time.

# The 17 equations that changed the course of history (spoiler alert: we use 3 of these equations in Finance 4335!)

Equations (2), (3), and (7) play particularly important roles in Finance 4335!

From Ian Stewart’s book, these 17 math equations changed the course of human history.

# Markets’ Steady Climb in 2017 Defies Historic Odds

This WSJ article provides helpful historical context concerning stock market volatility and performance.  The lowest daily VIX closing price ever recorded in its 27-1/2 year history was 9.31 on December 22, 1993 (followed by 9.48 the following day – December 23, 1993).   The closing price for VIX of 9.51 on July 14 is the third lowest close on record. The long-run average for VIX comes in at around 20, and the highest close ever recorded was 80.86 on November 20, 2008 (during the throes of the global financial crisis of 2008).

Three major stock-market benchmarks in the U.S., Europe and Asia have avoided pullbacks this year, commonly defined as 5% declines from recent highs.

According to this BloombergBusinessWeek article dated June 22, 2017, the best paid, most vulnerable occupations include “… accountants, benefits managers, credit analysts, and various insurance professionals”… (the y axis measures average annual wage for various occupations, and the x axis measures the likelihood of these occupations going away due to automation.

Use this tool to find out if robots are the future of your profession.
bloomberg.com

# The Snowballing Power of the VIX, Wall Street’s Fear Index

Great article about market volatility and how volatility has become an asset class unto itself.

Created to track expectations of volatility, it has spawned a giant trading ecosystem that could magnify losses when turbulence hits.

# Index Funds Still Beat ‘Active’ Portfolio Management

Princeton professor Burton Malkiel (author of “A Random Walk Down Wall Street“, now in its 11th edition, and chief investment officer for Wealthfront) explains why indexed investment is by far and away the best strategy for preserving and growing one’s savings.  For a very compelling and more in-depth treatment of this topic, I highly recommend also listening to Barry Ritholtz’s recent interview of Professor Malkiel  @ https://www.bloomberg.com/news/audio/2017-03-31/replay-interview-with-burt-malkiel-masters-in-business-audio.

There is no better way for individuals to invest in the stock market and save for retirement.