Coping with Risks through Mismatches: Domestic and International Financial Contracts for Emerging Economies

Authors

  • Augusto De La Torre,

    1. † Senior Advisor, Latin American and the Caribbean Region
      ‡ Senior Economist, Development Research Group
      World Bank, Washington, DC. adelatorre@worldbank.org sschmukler@worldbank.org
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  • Sergio L. Schmukler

    1. † Senior Advisor, Latin American and the Caribbean Region
      ‡ Senior Economist, Development Research Group
      World Bank, Washington, DC. adelatorre@worldbank.org sschmukler@worldbank.org
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    • *The authors are Senior Advisor, Latin American and the Caribbean Region, and Senior Economist, Development Research Group, respectively. This paper was finalized while Schmukler was visiting the IMF Research Department in 2004. For helpful comments, we are grateful to Ricardo Caballero, Mauricio Cárdenas, Ricardo Hausmann, Alejandro Izquierdo (Referee), Olivier Jeanne (Referee), Eduardo Levy Yeyati, Benn Steil (the Editor), Guillermo Perry, and participants at the IADB/World Bank conference ‘Financial Dedollarization: Policy Options’. We are grateful to Juan Carlos Gozzi Valdez and Marina Halac for outstanding research assistance. The paper is part of a broader study on capital markets, conducted at the Chief Economist Office, Latin America and the Caribbean Region, World Bank. The views in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank.


Augusto de la Torre
Sergio L. Schmukler
World Bank
1818 H Street NW
Washington, DC 20433
USA

Abstract

We analyse how short termism, dollarization and foreign jurisdictions are ways of coping with systemic risks prevalent in emerging economies. These are symptoms at least as much as problems. We conclude first that under high systemic risks, the market equilibrium settles in favour of investor protection against price risk (through short-duration peso and dollar contracts) instead of protection against default risk. Second, the option value to litigate in the event of default, which is higher in dollar and foreign-jurisdiction contracts, may explain this equilibrium outcome and, more generally, the ‘original sin’. Third, dollar contracts trump short-duration peso contracts as a risk-coping device; they are a better hedge against inflation volatility and are superior at mitigating the risk of loss given default. Fourth, according to a conservation principle, the mitigation of risk via the use of a coping mechanism allows additional risk taking in other forms, leaving total risk unchanged.

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