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Insuring Against Self-Fulfilling Financial Crises

  • C. Y. Cyrus Chu

    (Institute of Economics, Academia Sinica, Taiwan)

  • Jason J. H. Yeh

    (Department of Finance, Chinese University of Hong Kong, Hong Kong)

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    This paper proposes an insurance scheme to protect a currency from self-fulfilling financial crises. Treating such crises as catastrophes, the recently developed catastrophe insurance bond (CAT bond) can be adapted and applied. The idea is for the insured currency area to issue bonds with an interest payment higher than market alternatives and relieve the area's debt burden (principal and interest) in case of a catastrophic crisis. There are two purposes behind such a design: first, if a crisis occurs, the area being hit can use the forfeited principal as funds to recover; second and more importantly, the bondholders will have an incentive to defend against the speculative attack causing the crisis because they will themselves want to avoid the forfeiture of their debt principal. We study two typical models with self-fulfilling expectations by Obstfeld (1996) and Krugman (1999) and analyze the resulting equilibrium with and without the CAT bond. It is shown that under some conditions, the insurance scheme can indeed help to reduce the threat of a self-fulfilling financial crisis.

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    Article provided by College of Business, and College of Finance, Feng Chia University, Taichung, Taiwan in its journal International Journal of Business and Economics.

    Volume (Year): 4 (2005)
    Issue (Month): 2 (August)
    Pages: 123-139

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    Handle: RePEc:ijb:journl:v:4:y:2005:i:2:p:123-139
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    1. Kenneth A. Froot, 2001. "The Market for Catastrophe Risk: A Clinical Examination," NBER Working Papers 8110, National Bureau of Economic Research, Inc.
    2. Obstfeld, Maurice, 1996. "Models of Currency Crises with Self-fulfilling Features," CEPR Discussion Papers 1315, C.E.P.R. Discussion Papers.
    3. Cummins, J. David & Doherty, Neil & Lo, Anita, 2002. "Can insurers pay for the "big one"? Measuring the capacity of the insurance market to respond to catastrophic losses," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 557-583, March.
    4. Stephen J. Brown & William N. Goetzmann & James Park, 1998. "Hedge Funds and the Asian Currency Crisis of 1997," NBER Working Papers 6427, National Bureau of Economic Research, Inc.
    5. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
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