Recent debate about reforming the international financial architecture to handle financial crises in emerging markets typically focuses on the relationship between officials. That is, what will finance ministers from developed countries and officials in international financial institutions agree to tell finance ministers in emerging economies? However, in recent times, the motives for this may be ill-conceived as Schwartz (1998: 255) notes, "U.S.-backed bailouts protect investors who lent money to governments or private-sector institutions, not the people who suffer the consequences of unsound policies." Meanwhile, as a currency or sovereign-debt crisis unfolds it may spread to other asset classes and across countries, and the official response may be delayed.
What follows is a summary of proposals that some global investors might eventually rind useful for managing the risk of a country's exposure to a crisis with derivatives, without having to sell-off the country's real and primary financial assets. To do this requires (1) creating an index that quantifies the risk in question, (9.) instituting a derivative security that can be priced, which pays out when the risk is affecting investments, and (3) finding a way to guide trading strategies. The indexes explored are a country's beta, measuring the risk added to global investments from an additional dollar invested in the country, and a country's alpha, measuring how well the country performs relative to average global investments, after adjusting for global systematic risk. Such derivatives may spell the end of the transmission of future Tequila and Asian Crisis risks.
Resolving Emerging Financial Market Crises: A Myriad of Potential Policies or One, More Complete, Market?
Identifying the causes of emerging market financial crises and how such crises can be stopped has been the subject of much debate in recent years. There are presumably many relevant policies to prevent financial crises. Yet, there may be one simple market solution to dampen the effects that financial crises have on our wealth. The economist's task is to figure out how to create a more "complete" market in the sense of making financial risk economically irrelevant. The complete markets methodology is described in the next section and then applied to hedging emerging market investments against financial crises.
Kenneth Arrow (1953 in French, 1964 in English) proposes an elegant theory that defines the concept of a world of complete markets, in which shocks have no effect on the economy. In that world, the likelihood of any uncertainty can be quantified and priced, without giving up any resources because, by assumption, contracts are costless to create and enforce. When markets are complete, risk factors may affect our lives but not our livelihoods. Likewise, if risk affects our wealth, then it must be the case that markets are incomplete. The instruments used to complete markets are called state-contingent securities because they pay out a specified amount of money only if a particular state of nature is realized and nothing otherwise. As an example, imagine that we knew that tomorrow there would be an earthquake, a hurricane, or a calm, sunny day. Markets would be complete if we each owned a security that paid us one dollar if there is an earthquake and zero otherwise, a second security that paid us one dollar if there is a hurricane and zero otherwise, and a third that only paid us one dollar for sunshine and zero otherwise. The values of these securities would be tied to the probability of each event's occurrence. Arrow even proved that markets would be complete if we did not have all securities as long as the missing ones could be recreated from the ones we did have. For example, if only the second and third securities existed, the economic impact of the earthquake could still be neutralized if those two securities were combined in such a way that the payoff from the missing earthquake security could be mathematically recreated. …