Managing Default Risk for Commodity Dependent Countries: Price Hedging in an Optimizing Model
AbstractMacroeconomic volatility, in particular from exposure to volatile terms of trade in the form of volatile commodity prices, is an important source of risk for emerging market countries. As a consequence of this exposure, it has been argued, their probability of facing solvency problems on payments of their foreign currency debt is high, as are the country risk premia they must pay in order to borrow from international capital markets. While the availability of derivative contracts on many major commodity prices makes it possible to hedge commodity price exposure, many emerging market sovereigns either do not hedge a significant amount of their fiscal exposure to their major exports and import commodities or do not clearly report their hedging activities. In light of this phenomenon, and with the goal of crisis prevention in mind, we illustrate how a country exposed to shocks can execute its own insurance strategy against fluctuations in the prices of its major export commodities using futures and options markets. In the context of a model of sovereign default with endogeous sovereign spread and debt choice (Catao and Kapure (2004)), we demonstrate the resulting benefits of this insurance in terms of increased welfare for the country, a reduced soverign spread, and a higher debt ceiling. Additionally, we highlight some political economy problems leaders might face that hinder them from hedging in practice, and describe a hedging strategy to overcome these problems.
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Bibliographic InfoPaper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 246.
Date of creation: 01 Oct 2005
Date of revision:
Sovereign Default; Hedging; Macroeconomic Volatility;
Find related papers by JEL classification:
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-03-18 (All new papers)
- NEP-FMK-2006-03-18 (Financial Markets)
- NEP-MAC-2006-03-18 (Macroeconomics)
- NEP-PBE-2006-03-18 (Public Economics)
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