Abstract

http://ssrn.com/abstract=703241
 
 

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A Quantitative Model of Sudden Stops and External Liquidity Management


Ricardo J. Caballero


Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Stavros Panageas


University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

April 4, 2005

MIT Department of Economics Working Paper No. 05-10

Abstract:     
Emerging market economies, which have much of their growth ahead of them, run persistent current account deficits in order to smooth consumption intertemporally. The counterpart of these deficits is their dependence on capital inflows, which can suddenly stop. In this paper we develop and estimate a quantifiable model of sudden stops and use it to study practical mechanisms to insure emerging markets against them. We first assess the standard practice of protecting the current account through the accumulation of international reserves and conclude that, even when optimally managed, this mechanism is expensive and incomplete. External insurance, on the other hand, is hard to obtain because sudden stops often come together with distress in emerging market investors themselves (the most natural insurers). Thus, one needs to find global (non-emerging-market-specific) assets that are correlated to sudden stops. We show an example of such an asset based on the S&P 500's implied volatility index. If added to these countries portfolios, it would significantly enhance their sudden stop risk-management strategies. In our simulations, the median gain in terms of reserves available at the time of sudden stop is around 30 percent. Moreover, in instances where the level of non-contingent reserves is low, the median gain is close to 300 percent. We also find that as countries manage to reduce the size of the sudden stops that afflict them, they should reduce their stock of reserves and significantly increase their share of contingent reserves. The main insights of the paper extend to external liquidity and liability management more generally.

Number of Pages in PDF File: 51

Keywords: Capital flows, sudden stops, reserves, international liquidity and liability management, specialists, world capital markets, swaps, insurance, hedging, options, hidden states, Bayesian methods

JEL Classification: E2, E3, F3, F4, G0, C1

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Date posted: April 12, 2005  

Suggested Citation

Caballero, Ricardo J. and Panageas, Stavros, A Quantitative Model of Sudden Stops and External Liquidity Management (April 4, 2005). MIT Department of Economics Working Paper No. 05-10. Available at SSRN: http://ssrn.com/abstract=703241 or http://dx.doi.org/10.2139/ssrn.703241

Contact Information

Ricardo J. Caballero (Contact Author)
Massachusetts Institute of Technology (MIT) - Department of Economics ( email )
50 Memorial Drive
E52-252A
Cambridge, MA 02142
United States
617-253-0489 (Phone)
617-253-1330 (Fax)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Stavros Panageas
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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References:  26
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