Welfare Gains from Market Insurance: The Case of Mexican Oil Price Risk
IMF Working Papers, March 2, 2018
Source details
- Canonical URL
- Welfare Gains from Market Insurance: The Case of Mexican Oil Price Risk
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Bibliographic details
- Authors: Chang Ma, Fabian Valencia
- Published: March 2, 2018
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781484344163.001
Summary
- Over the past two decades, Mexico has hedged oil price risk through the purchase of put options.
- The paper examines resulting welfare gains using a standard sovereign default model calibrated to Mexican data.
- Main quantified result: welfare gains equivalent to a permanent increase in consumption of 0.44 percent.
- Attribution of gains: 90 percent of these gains stemming from lower risk spreads.
Methodology and Model
- Uses a standard sovereign default model calibrated to Mexican data.
- Focus on channels: reducing income volatility and reducing risk spreads on sovereign debt.
- Key concepts and technical terms preserved: sovereign default model, put options, income volatility, risk spreads, present discounted value, strike price, B welfare, bond price, default incentive.
Findings and Key Statistics
- Welfare gains equivalent to a permanent increase in consumption of 0.44 percent.
- 90 percent of welfare gains arise from lower risk spreads on sovereign debt.
- Hedging reduces income volatility and risk spreads, thereby increasing welfare.
- Subject areas emphasized: Asset prices; Financial institutions; Financial regulation and supervision; Hedging; Income; National accounts; Oil prices; Options; Personal income; Prices.
Policy Implications and Interpretation
- Market insurance via put options can yield measurable welfare improvements for a commodity-exporting sovereign.
- The reduction in sovereign risk spreads is the dominant channel through which hedging raises welfare.
- Hedging programs can be evaluated not only on smoothing income but also on their effect on sovereign borrowing costs.
Content in this bundle
- Welfare Gains from Market Insurance: The Case of Mexican Oil Price Risk, WP/18/35, March 2018