An Alternative Source of Funding to Mitigate Flood Losses through Bonds: A Model for Pricing Flood Bonds in Indonesian Territory

Abstract

Indonesia suffers significant economic losses from floods, and state budget allocations are often inadequate. Flood bonds provide an alternative funding source, but the pricing framework is complex due to simultaneous flood and financial risk considerations. Therefore, this study aims to model flood bond prices as an alternative flood funding in Indonesia. The model is formulated using the risk-neutral-pricing measure with the stochastic assumption of the force of interest. The claim trigger is represented as maximum rainfall, which is modeled as a continuous-stochastic process with a discrete-time index. Given the varying patterns of rainy and dry seasons, we assume both durations are dynamic. Then, we provide the approximate model solution for the government to estimate bond prices quickly. This estimation shows that the bond’s trigger point is proportional to the bond prices. Additionally, bond prices are proportional to the dry season duration and inversely proportional to the rainy season duration. We also show that using a stochastic force of interest yields significant differences from a constant one except for the constant as data average. This study can help the Indonesian government price flood bonds and provide more tools for related meteorological and climatological institutions to calculate the probability of future maximum rainfall.

Keywords

• flood bond
• price model
• Indonesia
• funding source
• risk-neutral-pricing measure
• stochastic force of interest