DEFINITION of 'Cat Spread'

A cat spread is a type of derivative traded on the Chicago Board of Trade (CBOT) that takes the form of an option on a catastrophe futures contract. In other words, a cat spread is basically a call option spread bought by insurance companies on catastrophe futures contracts. Purchasing a cat spread involves buying or selling a call option whose underlying asset is a catastrophe contract, while simultaneously selling or buying the same number of call options at a higher strike price. A cat spread is used by insurance companies to hedge risk coverage of catastrophic events.

BREAKING DOWN 'Cat Spread'

Let's say an insurance company buys a cat spread on a catastrophe futures contract with an expectation that the loss ratio on catastrophic events will fall within the range of 20% to 40%. If losses fall within that range, the insurance company would exercise the option and sell the contract, enabling the company to make a profit which will be used to offset the losses. However, if the loss ratio does not fall within the 20% to 40% range, the option will expire at zero and the only thing the company has to lose is the original investment.

RELATED TERMS
  1. Catastrophe Loss Index - CLI

    An index used in the insurance industry to quantify the magnitude ...
  2. Catastrophe Insurance

    Insurance to protect businesses and residences against natural ...
  3. Short Leg

    Any contract in an option spread in which an individual holds ...
  4. Catastrophe Call

    A call provision in municipal bonds that allows for the early ...
  5. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
  6. Bull Call Spread

    An options strategy that involves purchasing call options at ...
Related Articles
  1. Insights

    The Dead Cat Bounce: A Bear In Bull's Clothing?

    Make sure you know the difference between a change in market outlook and short-term recovery.
  2. Trading

    Option Spread Strategies

    Learn why option spreads offer trading opportunities with limited risk and greater versatility.
  3. Trading

    Trading Calendar Spreads In Grain Markets

    Futures investors flock to spreads because they hold true to fundamental market factors.
  4. Trading

    Vertical Bull and Bear Credit Spreads

    This trading strategy is an excellent limited-risk strategy that can be used with equity as well as commodity and futures options.
  5. Trading

    S&P 500 Options On Futures: Profiting From Time-Value Decay

    Writing bull put credit spreads are not only limited in risk, but can profit from a wider range of market directions.
  6. Insurance

    How Catastrophic Health Insurance Works

    Catastrophic health insurance is open to people under 30 and those who qualify by income under the Affordable Care Act. But how exactly does it work?
  7. Trading

    Which Vertical Option Spread Should You Use?

    Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.
  8. Investing

    How To Calculate The Bid-Ask Spread

    It's very important for every investor to learn how to calculate the bid-ask spread and factor this figure when making investment decisions.
RELATED FAQS
  1. How do I set a strike price in an options spread?

    Find out more about option spread strategies, and how to set the strike prices for bull call spreads and bull put spreads ... Read Answer >>
  2. What's the difference between a credit spread and a debt spread?

    Learn about debit and credit option spread strategies, how these strategies are used, and the differences between debit spreads ... Read Answer >>
  3. How do the investment risks differ between options and futures?

    Learn what differences exist between futures and options contracts and how each can be used to hedge against investment risk ... Read Answer >>
  4. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
  5. What is Warren Buffett's relation to "Supercat" insurance?

    Understand the concept of catastrophe reinsurance and learn how Berkshire Hathaway makes billions providing such insurance ... Read Answer >>
  6. What are the biggest risks involved with financial spread betting?

    Learn about financial spread betting, the risks involved with spread betting and the dangers of placing financial spread ... Read Answer >>
Hot Definitions
  1. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  2. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  3. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  4. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  5. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
  6. Gross Domestic Product - GDP

    The monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
Trading Center