Commodity Price Risk Management and Fiscal Policy in a Sovereign Default Model

43 Pages Posted: 1 Apr 2017

Date Written: March 2017

Abstract

Commodity prices are an important driver of fiscal policy and the business cycle in many developing and emerging market economies. We analyze a dynamic stochastic small-open-economy model of sovereign default, featuring endogenous fiscal policy and stochastic commodity revenues. The model accounts for a positive correlation of commodity revenues with government expenditures and a negative correlation with tax rates. We quantitatively document the extent to which the utilization of different financial hedging instruments by the government contributes to lowering the volatility of different macroeconomic variables and their correlation with commodity revenues. An event analysis illustrates how financial hedging instruments moderate fiscal adjustment in response to significant falls in the price of commodities. We evaluate the conditional and unconditional welfare gains for the representative household, generated by financial derivatives and commodity-indexed bonds.

Paper produced as part of the BIS Consultative Council for the Americas Research Network project "The Commodity Cycle: Macroeconomic and Financial Stability Implications"

Keywords: commodity revenues, hedging, indexed bonds, fiscal policy, sovereign default

JEL Classification: F34, F41, F44

Suggested Citation

Lopez-Martin, Bernabe and Leal, Julio and Martinez Fritscher, Andre C., Commodity Price Risk Management and Fiscal Policy in a Sovereign Default Model (March 2017). BIS Working Paper No. 620, Available at SSRN: https://ssrn.com/abstract=2941030

Bernabe Lopez-Martin (Contact Author)

Banco de México ( email )

Av. 5 de Mayo 18
Piso 4
Mexico City, 06059
Mexico

Julio Leal

Banco de México ( email )

Av. 5 de Mayo 18
Piso 4
Mexico City, 06059
Mexico

Andre C. Martinez Fritscher

Banco de México ( email )

Av. 5 de Mayo 18
Piso 4
Mexico City, 06059
Mexico

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