Exploring the Effectiveness of Using Risk Reduction Instruments to Hedge against Extreme Rainfall Events in the Framework of Extreme Value Theory

Risk management for natural disasters is an important issue, especially in a rainy country like Taiwan where extreme rainfall can lead to significant economic losses. However, the availability of financial tools to diversify catastrophic risk is limited in the local insurance market. Therefore, this study aims to explore the effectiveness of financial tools used by some countries in the past to hedge against natural disaster risk. These financial tools were based on the concept of alternative risk transfer (ART).

 

The goal of this study is to create a financial module within a natural disaster model to calculate the financial losses caused by Taiwan's monsoon, typhoon, and convectional rainfall, and produce expected losses table (ETL Table). The study then use the statistical framework of extreme value theory (EVT) to simulate the loss caused by these three types of rainfall in the form of extreme events. This will provide a more accurate assessment of the potential economic impact of these types of natural disasters on Taiwan.

 

Furthermore, the study uses the CIR (Cox-Ingersoll-Ross) stochastic process to simulate Taiwan’s overnight interbank lending rate (Taiwan LIBOR). This is important because changes in the interbank lending rate affects the cost of borrowing for businesses and individuals, which in turn can impact the overall economy. By understanding how the interbank lending rate changes in the event of a natural disaster, financial institutions and policymakers can make more informed decisions about how to respond to such events.

 

Finally, the study uses the Monte Carlo method to price catastrophe bonds, insurance, and futures. This provides a more accurate assessment of the potential financial value of these instruments, which can be used to hedge against natural disasters. By understanding the value of these financial tools, investors can therefore make more informed decisions about how to allocate their resources to protect against potential losses caused by natural disasters.

 

Overall, this study strives to gain a deeper understanding of the financial tools that can be used to hedge against natural disaster risk, and how these tools can be applied to reduce the economic losses caused by extreme rainfall in Taiwan. By understanding the successes and challenges of these tools in other countries, Taiwan can better design and implement its own risk management strategies to protect against the financial impacts of natural disasters.

 

The authors gratefully acknowledge the financial support from the National Science and Technology Council of Taiwan ( Grant Number: 111-2124-M-002-006)