An Intergenerational Cross-Country Swap
35 Pages Posted: 22 Apr 2009 Last revised: 16 Apr 2010
Date Written: April 21, 2009
This paper addresses the issue of intergenerational and international sharing of longevity and growth risks. Current research on worldwide demographic changes highlights the importance of longevity risk on financial markets and the need to devise optimal hedging vehicles. We present a potential financial innovation between two countries at different stages of economic development and with different long-term challenges. This 30-year-long swap is structured in such a way to capture the different timing of needed funds of the two countries and the funding capabilities of each generation: the more developed economy requires funds in the future to cover expenses for its ageing population, while the developing economy needs funds today to pay for educational, technological, and other infrastructural services. To price the swap, we apply an exponential-utility-based pricing method and define an interval of prices allowing a contract to be agreed upon. We show how the bid-ask spread varies with respect to the governments' risk and time preferences.
Keywords: Financial innovation, longevity risk, population ageing, old-age dependency ratio, growth risk, exponential-utility-based pricing, intergenerational risk-sharing, international risk-sharing
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