Second, do you see a difference between your cat bond model and synthetic CDOs? I for one don’t see much of one. I can craft a hedge portfolio buying protection while the dealer packs it all in a SPV and sells the cash flows out to investors, which in essence describes a synthetic CDO. Maybe there’s something I’m missing and you can explain.

Thanks.

I see little incentive to buying a “cat bond” unless the yield is substantial, the buyers are taking all the deltas and fixing their vega, theta and rho price at the beginnings, so I would expect the the vega and rho to carry premium.

The hedge fund is essentially buying rolling puts at a fixed price–eliminating it’s greek risk–from the SPV, which is in turn passing premiums to the bondholders, except reclassifying them as “interest.” Depending on how this is structured, the bond holders wouldn’t see a loss on principal until the options went binary, even though they were essentially long deltas that kept declining but were obscured away by the structure.

Is this really cheaper for a hedge fund than replicating the structure with vanillas? The only two advantages I see here are that the fund is fixing the insurance price–moving risk to the SPV and then bond holders–and that avoiding the use of vanillas for a custom structure eliminates the risk of moving the market / etc, but you could probably get the same thing with OTCs, and since the SPV hold collateral, it’s not like you are benefiting from circumventing haircuts / margin requirements, which was basically what the CDS trade was…

Now, in the case of a worthless expiration, what happens to whatever–if anything– is left over? is there an equity component? if so, does the fund own it, or is passed down to the cat bond sellers?

I don’t mean to put you on the spot, this is really an interesting post. I think about hedging tail risk a whole lot, but playing these games with financial instruments is just a battle against entropy, and the only value to be created is really a result of circumvention of legal and tax issues (converting cap gains to interest or divs, circumventing margin reqs, using OTCs to avoid information leakage)

Generally, though, I am totally with you. In good times I make sure I have cash and borrowing power. I like to put cash to work in times of distress and add margin if it gets to downright crisis levels.

Another strategy I like is keeping delta-neutral long-gamma positions (via a gamma scalp) during good times and at vol. lows. They bleed relatively slowly, so they aren’t expensive, but when distress happens, volatility tends to sky-rocket and markets move fast, making it a great cash flow-generator (which you can then use to buy assets at their new, lower prices). Of course this all requires a certain size, plenty of attention and low friction costs.