Managing Default Risk for Commodity Dependent Countries: Price Hedging in an Optimizing Model

In: https://ora.ox.ac.uk/objects/uuid:e1354a40-2e1a-4902-afea-b0d1bbfacdf8

Open Access

Abstract

Macroeconomic 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 export and import commodities or do not clearly report their hedging activities. In this of 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 endogenous sovereign spread and debt choice (Catao and Kapur (2004)), we demonstrate the resulting benefits of this insurance in terms of increased welfare for the country, a reduced sovereign 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.