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Average Rate Claims with Emphasis on Catastrophe Loss Options

Published online by Cambridge University Press:  06 April 2009

Gurdip Bakshi  and
Dilip Madan
Gurdip Bakshi
Affiliation:
[email protected], Department of Finance, Robert H. Smith School of Business, University of Maryland, College Park, MD 20742.
Dilip Madan
Affiliation:
[email protected], Department of Finance, Robert H. Smith School of Business, University of Maryland, College Park, MD 20742.
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Abstract

This article studies the valuation of options written on the average level of a Markov process. The general properties of such options are examined. We propose a closed-form characterization in which the option payoff is contingent on cumulative catastrophe losses. In our framework, the loss rate is a mean-reverting Markov process, with no continuous martingale component. The model supposes that high loss levels have lower arrival rates. We analytically derive the cumulative loss process and its characteristic function. The resulting option model is promising.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 37 , Issue 1 , March 2002 , pp. 93 - 115
Copyright
Copyright © School of Business Administration, University of Washington 2002

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