Question

Catastrophe bonds are attractive to investors because their payoffs are uncorrelated with the market portfolio (i.e. they are almost zero-beta assets)

a) True
b) False

Answer 1

Bonds carry interest rate, credit, and inflation risks, which make them somewhat risky despite predetermined payments. Catastrophe bonds, however, are attractive because they are uncorrelated with market performance and are associated with specific events such as natural disasters.

Step-by-step explanation:

Bonds are considered to be somewhat risky investments even with their predetermined payments due to several factors. Here are a few risks associated with buying bonds:

• Interest Rate Risk: When market interest rates rise, the value of existing bonds with lower interest rates falls, as newer bonds may be issued at the higher rates.
• Credit Risk: There is always the risk that the bond issuer may default on their obligations, leading to partial or total loss of the investment.
• Inflation Risk: Inflation can erode the purchasing power of the fixed payments from bonds, particularly if the rate of inflation outpaces the interest rate on the bond.

In the case of catastrophe bonds, they are attractive to investors because their payoffs are uncorrelated with the market portfolio, meaning they're almost zero-beta assets. This is true because their performance is linked to specific events such as natural disasters, not market fluctuations.