CAS Exam 9 Spring 2015, Question 14
Study guide: Exam 9
A country recently began allowing financial institutions to package catastrophe (CAT) bonds into collateralized debt obligations (CDO) that allowed tranches to be constructed based on the performance of the underlying CAT bonds.
Critics objected that allowing CAT bond CDO tranches with AAA ratings could lead to a repeat of the subprime mortgage crisis.
Part a (1.5 points)
Discuss three ways the risks associated with CAT bond CDOs differ from the collateralized mortgage obligations constructed before the subprime financial crisis.
Part b (1 point)
Discuss two potential challenges arising from widespread construction and investment in the CAT bond CDOs that could contribute to a future financial crisis.
Part c (1 point)
Propose and briefly explain two possible regulations for construction or rating of the new CAT bond CDOs that could help alleviate some of the challenges in part b. above, without greatly discouraging innovation and investment.
Answer this question and see the worked solution