Country Insurance Using Financial Instruments

IMF Working Papers, July 1, 2011

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Financial instruments tied to indices that track global financial conditions and risk appetite can potentially offer countries alternative options to insure against external shocks.
These instruments can explain much of the in-sample variation in borrowing spreads.
Hedging strategies based on these instruments fail to perform well out-of-sample during tranquil times.
Positions on instruments tracking the US High Yield Spread, the VIX, and especially other emerging market CDS spreads can substantially offset adverse movements in a country’s own spreads during times of systemic crises.
High risk countries appear to gain more from such instruments, as their underlying weaknesses make them more vulnerable to external shocks.
The limited value of these instruments in tranquil times, together with political economy arguments and innovation costs, could justify the limited interest in this type of hedging in practice.

Hedging strategies should account for differing performance in tranquil versus systemic-crisis periods:
- Tranquil times: limited hedging effectiveness out-of-sample.
- Systemic crises: notable offsetting benefits from positions on US High Yield Spread, VIX, and emerging market CDS indices.
Countries with higher vulnerability to external shocks (high risk countries) may derive greater insurance value from these instruments.
Policymakers should weigh:
- The episodic nature of effectiveness (crisis vs. tranquil periods).
- Political economy considerations that may limit implementation.
- Innovation and transaction costs associated with adopting such financial instruments.