Innovative Derivatives to Drive Investment in Earthquake Protection Technologies

Abstract

We propose derivatives that compensate for the preparation cost to a building owner unless a specified earthquake occurs. By purchasing the derivatives, the building owner should pay for the earthquake protection only when the specified earthquake occurs. Otherwise the additional preparation cost will be covered by the derivative counterparty. In exchange for the coverage, the building owner is required to deposit a principal, which is lost when the earthquake happens. The proposed derivatives are expected to result in the efficient promotion of earthquake protection technologies in seismic regions. This chapter presents a scheme to swap the cash flow with a regular catastrophe bond. The price of the proposed derivatives is the ratio of the notional amount to the compensation given the earthquake does not take place. The pricing is formulated based on credit default swap (CDS) pricing. We present a numerical example using an actual cat bond, where up-to-date seismological models are introduced into pricing.

This chapter was submitted to the Applied Financial Project of Master of Financial Engineering, Haas School of Business, University of California at Berkeley, and won the Gifford Fong Associate Prize.