Why hedge fund managers watch the weather forecast

The weather will be an important subject at Wall Street as fall is slowly arriving. In the US the end of the summer usually brings the Hurricane Season. The floods of New Orleans are still in everybody's mind and is only understandable that this season is expected with nervous anxiety. In the financial community the subject is now launched with the rediscovery of a special financial instrument, the so-called Catastrophe Bonds (Cat Bonds). Cat Bonds are issued by reinsurance companies and offer yields which may be 5 to 15 percent higher than US treasuries. These bonds have been in the market for a long time, but it was the series of last year's disasters that brought them back into the spotlight.

For issuers such as Swiss Re or Hanover Re Cat Bonds are used to diversify the risk portfolio. Insurance companies can transfer part of their risks to the capital markets, where numerous hedge funds are willing to invest in disaster risks. Cat Bonds feature an attractive yield, but they can also become worthless in the case of a disaster. In other words: hedge funds buy a bond with an attached option which is activated in a pre-defined scenario liberating the issuer from its duty to refund. In this case, the hedge funds suffers the downside of the instrument.

This risk may be seen as a deterrent. On the other hand, it would take a century disaster to fulfil the conditions of a total investment loss. The probability of such a disaster is rated by the experts with a chance of 1 to 100 by experts or even higher. So far, investors were always refunded at the end of the term.

Source: Neue Zürcher Zeitung


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