David Cummins and Christopher Lewis
Abstract —Recent years have seen the introduction of a new class of derivative securities based on “exotic underlyings” such as natural catastrophes and weather. This paper analyzes the pros and cons of these new securities as assets for institutional investors. It is argued that the underlyings on which these derivatives trade have very low correlations with other factors that move the investment markets, potentially enabling investors to shift the efficient investment frontier in a favorable direction. However, there in very little data on the effects on the market of a large natural catastrophe, and these securities may be especially susceptible to liquidity problems and credit risk. The paper explores these issues in more detail, as well as providing information on the actual and optimal design of such contracts.