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Temporary Stabilization and the Real Option of Waiting when Consumption can be Delayed: an Extreme Value Approach

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  • Francisco Venegas-Martínez

Abstract

This paper develops, in a small open economy framework, a stochastic model of exchange-rate-based inflation stabilization that is expected to be temporary. Agents have expectations of devaluation driven by a mixed diffusion-jump process where the expected size of a possible devaluation is supposed to have an extreme value distribution of the Fréchet type; as the stylized facts from the Mexican's 1994 and Argentinean's 2001 cases have show n. Consumption and wealth equilibrium dynamics are examined when a stabilization plan is implemented. The case of a stochastic stabilization horizon guided by an exponential distribution is studied. Moreover, this paper also deals with pricing the real option of waiting for postponing consumption when a stabilization plan is about to be abandoned; a claim on a non-traded asset. We also assess the effects of exogenous shocks on consumption and economic welfare. Finally, we use the proposed model to carry out simulation experiments that reproduces the booms of private consumption in the Mexican case of 1989-1994 and the Argentinean case of 2001-2003, which resulted in extreme devaluations.

Suggested Citation

  • Francisco Venegas-Martínez, 2005. "Temporary Stabilization and the Real Option of Waiting when Consumption can be Delayed: an Extreme Value Approach," DEGIT Conference Papers c010_043, DEGIT, Dynamics, Economic Growth, and International Trade.
    • Handle: RePEc:deg:conpap:c010_043
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    References listed on IDEAS

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    1. Venegas-Martinez, Francisco, 2006. "Stochastic temporary stabilization: Undiversifiable devaluation and income risks," Economic Modelling, Elsevier, vol. 23(1), pages 157-173, January.
    2. Enrique G. Mendoza & Martin Uribe, 1996. "The syndrome of exchange-rate-based stabilizations and the uncertain duration of currency pegs," International Finance Discussion Papers 548, Board of Governors of the Federal Reserve System (U.S.).
    3. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    4. Enrique G. Mendoza & Martin Uribe, 1998. "The business cycles of currency speculation: a revision of the Mundellian framework," International Finance Discussion Papers 617, Board of Governors of the Federal Reserve System (U.S.).
    5. Sergio Rebelo & Carlos A. Végh, 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," NBER Chapters, in: NBER Macroeconomics Annual 1995, Volume 10, pages 125-188, National Bureau of Economic Research, Inc.
    6. Francisco Venegas Martínez, 2005. "Política fiscal, estabilización de precios y mercado incompletos," Estudios Económicos, El Colegio de México, Centro de Estudios Económicos, vol. 20(1), pages 3-25.
    7. Guillermo A. Calvo & Allan Drazen, 1997. "Uncertain Duration of Reform: Dynamic Implications," NBER Working Papers 5925, National Bureau of Economic Research, Inc.
    8. Uribe, Martin, 1997. "Exchange-rate-based inflation stabilization: The initial real effects of credible plans," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 197-221, July.
    9. Strobel, Frank, 2005. "Monetary integration and inflation preferences: A real options analysis," European Economic Review, Elsevier, vol. 49(4), pages 845-860, May.
    10. Allan Drazen & Elhanan Helpman, 1987. "Stabilization with Exchange Rate Management," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 102(4), pages 835-855.
    11. Carlos A. Végh, 1992. "Stopping High Inflation: An Analytical Overview," IMF Staff Papers, Palgrave Macmillan, vol. 39(3), pages 626-695, September.
    12. Venegas Martínez, Francisco & Fundia Aizenstat, Andrés, 2006. "Opciones reales, valuación financiera de proyectos y estrategias de negocios. Aplicaciones al caso mexicano," El Trimestre Económico, Fondo de Cultura Económica, vol. 0(290), pages 363-405, abril-jun.
    13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    14. Venegas-Martinez, Francisco, 2001. "Temporary stabilization: A stochastic analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 25(9), pages 1429-1449, September.
    15. Henderson, Vicky & Hobson, David G., 2002. "Real options with constant relative risk aversion," Journal of Economic Dynamics and Control, Elsevier, vol. 27(2), pages 329-355, December.
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    More about this item

    Keywords

    Inflation stabilization; Contingent claims; Extreme values;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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