Commodity Price Default

Journal of International Money and Finance 96 (2019) 304–323
Contents lists available at ScienceDirect
Journal of International Money and Finance

journal homepage: www.elsevier.com/locate/jimf
Commodity price risk management and fiscal policy in a

sovereign default model q
Bernabe Lopez-Martin ⇑, Julio Leal, Andre Martinez Fritscher
Banco de México, Mexico
a r t i c l e i n f o a b s t r a c t
Article history: Commodity prices are an important driver of fiscal policy and the business cycle in many
Available online 18 July 2017 developing and emerging market economies. We analyze a dynamic stochastic small-open-
economy model of sovereign default, featuring endogenous fiscal policy and stochastic
JEL classification: commodity revenues. The model accounts for a positive correlation of commodity revenues
F34 with government expenditures and a negative correlation with tax rates. We quantitatively
F41 document the extent to which the utilization of different financial hedging instruments by
F44
the government contributes to lowering the volatility of different macroeconomic variables
Keywords: and their correlation with commodity revenues. An event analysis illustrates how financial
Commodity revenues hedging instruments moderate fiscal adjustment in response to significant falls in the price
Hedging of commodities. We evaluate the conditional and unconditional welfare gains for the repre-
Indexed bonds sentative household, generated by financial derivatives and commodity-indexed bonds.
Fiscal policy Ó 2017 Elsevier Ltd. All rights reserved.
Sovereign default
1. Introduction
Commodity prices are an important driver of the behavior of fiscal policy and the business cycle in commodity exporting
developing and emerging market economies.1 Among other factors, these results have been attributed to the fact that
governments in many economies rely to an important extent on commodity revenues to finance their budgets. For example,
in more than twenty countries hydrocarbon revenues account for over thirty percent of total fiscal revenue (IMF, 2007). Given
q
For comments and suggestions we are grateful to Ana Maria Aguilar, Joshua Aizenman, Enrique Alberola, George Alessandria, Nicolas Amoroso, Eduardo
Borensztein, Luis Catão, Julio Carrillo, Alfonso Cebreros, Enrique Covarrubias, Daniel Chiquiar, Gabriel Cuadra, Stephan Danninger, Javier Garcia-Cicco, Franz
Hamann, Gerardo Hernandez del Valle, Juan Ramon Hernandez, Alfredo Ibañez, Raul Ibarra, Olivier Jeanne (discussant), Timothy Kehoe (discussant),
Emanuel Kohlscheen, Oleksiy Kriyvtsov, Enrique Mendoza, Ramon Moreno, Fernando Perez-Cervantes, Jessica Roldan-Peña, Daniel Samano, Alberto Torres,
Rick van der Ploeg, Fabrizio Zampolli and participants of the BIS CCA Research Network (Mexico City 2015 and 2016), the NAFTA Central Bank Conference
(Bank of Canada, Ottawa 2016), the ITAM-PIER (U. Penn) Conference on Macroeconomics (Mexico City 2016), the Annual Conference at U. Iberoamericana
(Mexico City 2016) and the Midwest Macroeconomics Meetings (FRB Kansas City 2016). The views and conclusions presented here are exclusively those of
the authors and do not necessarily reflect those of Banco de México.
⇑ Corresponding author.
E-mail addresses: bernabe.lopez@banxico.org.mx (B. Lopez-Martin), jleal@banxico.org.mx (J. Leal), fritscher@yahoo.com (A. Martinez Fritscher).
1
For empirical evidence see Medina (2010), Villafuerte and Lopez-Murphy (2010), Spatafora and Samake (2012), Cespedes and Velasco (2014), Talvi and
Vegh (2005) and Fernandez et al. (2015). Husain et al. (2008) and Pieschacon (2012), among others, assert that fiscal policy is the key mechanism through
which oil prices affect the economic cycle in oil-exporting countries. For discussions and evidence of procyclical fiscal policy in developing economies see
Ilzetzki and Vegh (2008), Talvi and Vegh (2005), Frankel et al. (2013) and references therein. Vegh and Vuletin (2012) find that tax rate policy is procyclical in
most developing countries (tax rates are negatively correlated with GDP), but acyclical in developed economies.
http://dx.doi.org/10.1016/j.jimonfin.2017.07.006
0261-5606/Ó 2017 Elsevier Ltd. All rights reserved.
B. Lopez-Martin et al. / Journal of International Money and Finance 96 (2019) 304–323 305
their reliance on a highly volatile source of revenue, these economies face a significant challenge in terms of their capacity to
smooth fiscal policy and fluctuations in economic activity.
Different instruments have been proposed and implemented with the purpose of moderating the impact of commodity-
price fluctuations on public finances. In this article we exploit a dynamic model of sovereign default with endogenous fiscal
policy, introducing a stochastic endowment of commodity-revenues for the government, to contribute to our understanding
of the potential macroeconomic consequences of using these instruments.2 This model is a natural framework to illustrate the
trade-offs faced by a government subject to large fluctuations in commodity-related revenues as it endogeneizes the decisions
of public expenditures, distortionary tax rates, the issuance of debt and the default of sovereign debt. Furthermore, it allows us
to do so in a relatively standard business cycle environment.
In our framework, fluctuations in commodity prices affect the economy through their impact on the government budget
constraint and the ability of the government to access credit in international financial markets. As is standard in the sover-
eign default literature (which we discuss below), the incentives to default increase when income is low, which occurs when
aggregate productivity or when the price of commodities is low, or a combination of both. In these situations the likelihood
of default increases and investors are less willing to increase lending to the government, which induces the government to
rely more heavily on taxation to provide for expenditures. Since taxes are distortionary, higher taxes induce lower labor
input and thus lower non-resource output and private consumption. By calibrating the model to Mexico, we are able to
assess the quantitative performance of this mechanism.3
We use our framework to evaluate the business cycle and welfare implications of the utilization by the government of
different financial instruments that serve the purpose of moderating fluctuations in commodity-revenues: commodity
indexed bonds and financial derivatives.4 We quantify how these instruments generate a reduction in the volatility of different
macroeconomic variables and their correlation with commodity prices. We then compare how the economy reacts, under alter-
native scenarios, to significant drops in the price of commodities and illustrate how hedging instruments allow for a relatively
smooth adjustment of fiscal variables.
The use of this type of financial instruments is, of course, not a recent idea in the academic literature or in economic pol-
icy. In 1863 the Confederate States of America issued bonds payable in pounds sterling or French francs but convertible into
cotton at a predetermined price (Borensztein and Mauro, 2004). More recently, both sovereign countries and corporate enti-
ties have issued debt linked to the price of different commodities including gold and silver as well as oil (for a summary of
these experiences see Atta-Mensah, 2004). The government of Mexico is believed to be the first to issue oil-linked bonds dur-
ing the 1970s, known in financial markets as Petrobonds.5 Nigeria and Venezuela issued oil-linked bonds in the 1990s in
exchange for defaulted loans (Sandleris and Wright, 2013). The World Bank has made available loans combined with protection
from commodity price fluctuations, although with limited use (Borensztein and Mauro, 2004). There is also experience with the
use of financial derivatives. The federal government of Mexico has used financial risk management tools to hedge the risk of
fluctuations in the price of oil at least since the early 1990s (Daniel, 2001; IMF, 2007), and in a systematic manner since
2004. This experience suggests that producers can successfully exploit hedging opportunities provided by financial markets.
Most previous work in the literature has focused on studying the potential gains of issuing GDP-indexed sovereign debt.
This consists of financial instruments that specify payments according to the outcome of GDP. Therefore, a government that
issues these bonds faces lower debt payments during economic downturns, which can potentially facilitate countercyclical
fiscal policy and diminish the likelihood of fiscal crises as well as contribute to reduce the volatility of macroeconomic vari-
ables.6 Hatchondo and Martinez (2012), for example, introduce output-indexed bonds into an equilibrium sovereign default
model and calculate that the welfare gain from the introduction of these instruments is equivalent to 1/2 a percentage point
of consumption.7 The gains come from the result that these bonds allow the government to avoid costly default episodes,
increase the levels of debt and improve consumption smoothing.
2
Mendoza (1995) finds that terms-of-trade shocks account for approximately 1/2 of GDP variability in a dynamic stochastic small open economy framework.
Shousha (2016) estimates that innovations in real commodity export prices are responsible for 23 percent of movements in aggregate output in emerging
economies. Schmitt-Grohé and Uribe (2015) estimate that terms-of-trade shocks explain approximately 10 percent of movements in aggregate activity in less
developed and emerging economies while Fernandez et al. (2015) estimate a model that assigns to commodity shocks 42 percent of the variance in income.
3
Although we focus on the case of oil-revenues for Mexico, the implications derived from our model can be generalized to economies that rely on different
commodities for a significant proportion of their fiscal revenues. As we examine below, the model is able to replicate well the relationships between oil prices
and government expenditures reported by Pieschacon (2012) using a VAR approach for Mexico, the cyclical behavior of tax rates as documented by Vegh and
Vuletin (2012) for emerging economies and other regularities supported by the empirical literature.
4
We analyze the following scenarios: (1) baseline model with standard non-contingent bonds, (2) non-contingent bonds and use of forward sale of
commodities, (3) non-contingent bonds and use of sale options for commodities, (4) commodity indexed bonds. We view these instruments as complementary
to the role of stabilization funds aimed at smoothing fluctuations in international commodity prices (for a discussion see Daniel, 2001). In principle, hedging
strategies could reduce the need to accumulate wealth in stabilization funds and the cost of opportunity they imply.
5
http://www.banxico.org.mx/divulgacion/sistema-financiero/sistema-financiero.html
6
This literature includes Borensztein and Mauro (2004), Sandleris et al. (2008) and Durdu (2009).
7
This estimate could be considered an upper bound on the potential gains of GDP-indexed debt instruments since, among other assumptions, they specify a
portfolio of complete Arrow-Debreu securities instead of a single output-indexed bond. Their formulation eliminates sovereign default and its associated costs
in equilibrium given that foreign investors will not purchase assets that are contingent on a realization of GDP that results in default. As noted in the literature,
there may be obstacles to issuing this type of debt instruments, such as the possibility that GDP may no be easily verifiable. GDP-indexed bonds have also been
considered within a debt sustainability framework (for a discussion see Hatchondo and Martinez, 2012).
306 B. Lopez-Martin et al. / Journal of International Money and Finance 96 (2019) 304–323
The use of commodity-indexed debt instruments and financial derivatives has been proposed by authors such as Daniel
(2001) and Atta-Mensah (2004), among many others (see references in Borensztein and Mauro, 2004). Malone (2005) eval-
uates the benefits of using financial derivatives to hedge commodity price risk in a stylized two-period default model econ-
omy. Caballero and Panageas (2008) work with a sudden-stop model to study the case of Chile, where the business cycle is
influenced by the price of copper, and argue that existing financial markets could be exploited to hedge against variations in
the likelihood of a sudden-stop. Borensztein et al. (2015) analyze the welfare gains that a small open economy can derive
from insuring against natural disasters with catastrophe bonds.
Perhaps closest to our work is that of Borensztein et al. (2013). They also analyze the potential welfare gains of hedging
against commodity price risk for commodity exporting economies. In their model, hedging enhances welfare through two
channels: first, by reducing export income volatility; and second, by reducing the need to hold precautionary reserves
and improving the ability of the country to borrow against future export income. The contribution in our article is to evaluate
the use of financial instruments in a small open economy general equilibrium framework where tax rates, government
expenditures and debt levels are endogenous and depend on stochastic aggregate productivity as well as oil-revenues. In
addition to being able to study the behavior of different fiscal variables in our model, we further the analysis in
Borensztein et al. (2013) by considering an economy with endogenous non-resource output subject to productivity shocks,
as opposed to an exogenous fixed level. This opens the possibility of assessing a transmission mechanism from fiscal policy
to the private sector.8 Additionally, in our model the possibility of sovereign debt default determines endogenously how much
investors are willing to lend to the government, and this potentially depends on the capacity of the government to moderate the
volatility of commodity-related revenues. We show that, in contrast to Borensztein et al. (2013), in our model there is not sig-
nificant room for increasing average debt levels, as this is mainly determined by the cost-benefit trade-offs implied by default.
In our model the costs of default are generated by a loss in output and temporary exclusion from financial markets while the
volatility of commodity revenues plays a relatively limited role in the determination of debt levels.
Our exposition proceeds as follows: the economic environment and the description of our theoretical framework are pro-
vided in Section 2, we discuss the main mechanisms underlying our model in Section 3. The parameterization and calibration
approach are described in Section 4. In Section 5 we outline the different financial instruments that are introduced into the
model. Section 6 presents the quantitative analysis and our main results. Section 7 provides a final discussion and the
conclusion.
2. Quantitative framework
We exploit the canonical model of sovereign default of Cuadra et al. (2010), in the tradition of Eaton and Gersovitz (1981)
and Arellano (2008). The model features endogenous government expenditures (separated from private consumption), tax
rates and debt levels as well as endogenous household labor supply. Considering an elastic labor supply allows tax rates to
have a distortive effect on non-resource production, which represents the transmission mechanism from government policy
to the private sector in our model. We introduce an exogenous stochastic endowment of commodity revenues for the
government.
The environment consists of a small open economy model with three agents: a representative household, the government
and international lenders. The representative household values private consumption, government spending and leisure. In
every period the household makes a decision regarding labor supply taking as given the tax rate set by the government
and the aggregate productivity shock. The government maximizes the welfare of the household and has access to interna-
tional financial markets where it can borrow by issuing a one-period non-contingent bond. The government also decides on
the level of public spending and borrowing as well as the level of the tax rate. Furthermore, it can decide to default on its
debt obligations, which results in a loss in output and temporary exclusion from credit markets. Lenders charge a premium
on the interest rate paid by the government, which is based on the expected probability of default and a stochastic discount
factor. The stochastic discount factor is motivated by the observation that if governments tend to default when investors
have high marginal utility then bond prices reflect compensation for this risk.9
2.1. Households and production technology
There is a representative household with present expected discounted value of future utility flows represented by:
" #
X1
t
E b uðct ; g t ; 1 lt Þ ð1Þ
t¼0
where the discount factor is given by b and the per period utility function is specified in the following manner:
1þw 1r
g 1r ðct lt =ð1 þ wÞÞ
uðct ; g t ; 1 lt Þ ¼ p t
þ ð1 pÞ ð2Þ
1r 1r
8
We discuss an alternative potential transmission mechanism in the conclusion.
9
There is evidence that the risk premium is an important factor in accounting for the behavior of sovereign bond prices (see Lizarazo, 2013).
The representative household values private consumption ct , public expenditures g t and leisure 1 lt . Utility is separable in
private sector variables ct and lt and public expenditures g t . Parameter p determines the weight given to government expen-
ditures in the utility function. Parameter w governs the elasticity of the supply of labor by the household with respect to the
return to labor; in our model this return will be determined by the exogenous aggregate productivity level and the tax rate
set by the government (under this utility function specification the marginal rate of substitution between private consump-
tion and labor is independent of consumption). The coefficient of relative risk aversion is set by parameter r.
There is a tradable good produced using labor services with a production technology that is subject to productivity shocks
yt ¼ at f ðlt Þ, where productivity a takes on a finite number of values defined over the set Sa and evolves according to a tran-
sition matrix denoted by Kða0 j aÞ. Private consumption is taxed by the government, the representative household makes pri-
vate consumption and leisure decisions based on the budget constraint ð1 þ sÞ ct ¼ at f ðlt Þ, where s is the tax rate set by the

government at the beginning of the period.10 The optimal household decisions are written as c ða; sÞ and l ða; sÞ.
2.2. The dynamic problem of the government
The government maximizes the welfare of the representative household. In every period the government makes decisions
regarding the levels of debt it issues in international financial markets, the tax rate and government expenditures. Addition-
ally, the government can decide to default on its debt.
When the government has access to financial markets, the dynamic problem can be written in recursive form as follows:
X
v c ðb; a; zÞ ¼
max uðc ; g; 1 l Þ þ b Kða0 j aÞ Cðz0 j zÞ v ðb ; a0 ; z0 Þ
0
ð3Þ
f g; b0 ; sg
fa0 ; z0 g

subject to the optimal household functions c ðs; aÞ and l ðs; aÞ, which the government takes as given. The government budget
0 0
constraint is g ¼ s c þ b qðb ; a; zÞ b þ x, where b is the level of foreign assets (primes denote variables for the next period)
0
and x are commodity-revenues denominated in units of the tradable good. The price of bonds is a function qðb ; a; zÞ that is
endogenously determined in equilibrium and discussed below. Commodity-revenues x ¼ h z take on a finite number of val-
ues defined over the set Sx , where h is a (fixed) parameter that determines the average level of revenues and z is the exoge-
nous stochastic price of the commodity. This price is defined over the set Sz and evolves according to a discrete transition
matrix process denoted by Cðz0 j zÞ.11 The possibility of default is introduced in the expression
v ðb; a; zÞ ¼ maxfv c ðb; a; zÞ; v d ða; zÞg, where v d ða; zÞ is the value of default and v c ðb; a; zÞ is the value of maintaining access to
international credit markets.
When the government decides to default it temporarily loses access to international credit markets and its budget con-
straint becomes g ¼ s c þ x. Additionally, there is an efficiency loss in aggregate productivity represented by the function
hðaÞ 6 a (the rationale for this loss and the calibration approach are described in the calibration section). With no access
to financial markets the dynamic problem of the government is given by expression (4):
X
v d ða; zÞ ¼ max
fg; sg

uðcd ; g; 1 ld Þ þ b Kð Þ Cð Þ l v ðb ¼ 0; a0 ; z0 Þ þ ð1 lÞ v d ða0 ; z0 Þ
0
fa0 ; z0 g
subject to the budget constraint under default previously described and the optimal decisions of the household cd ðs; aÞ and

ld ðs; aÞ, when there is no access to international credit markets. The government regains access to financial markets with
probability l. 12
2.3. International lenders and the price of sovereign bonds
The price of sovereign bonds is determined according to a no-arbitrage condition that incorporates a stochastic discount
factor. International lenders have perfect information of the state of the economy (productivity, oil price and level of foreign
10
The government is the only domestic agent in this economy that can hold assets or borrow. In developing economies government debt can account for most
of external debt. In the case of Mexico, for example, during the financial crisis of 1995, sovereign external debt accounted for almost 70 percent of the total
stock of foreign debt (see Cuadra et al., 2010). Furthermore, the volume of total credit to the private sector has been historically low in Mexico (see Lopez-
Martin, 2016), as is typical in many developing economies. Additionally, we use the volatility of consumption as a target in our calibration procedure. We
abstract from the direct exposure of the private sector to commodity prices.
11
We abstract from fluctuations in quantities and focus on the risk implied by price volatility, for many commodities most of revenue fluctuations are
accounted for by price variations (see Bems and de Carvalho Filho, 2011; Borensztein et al., 2013). Spatafora and Samake (2012) carry out a variance
decomposition of commodity export revenues, their results suggest that prices largely drive changes in commodity export revenues: considering fuel-exporting
developing countries during the period 1990–2010 the pure price effect accounted for 73.5 percent of the variance, while the pure volume effect and the
correlation component accounted for 10.4 and 16.2, respectively (their Table 13). For the period 2000–2010 the pure price effect accounted for 77.5 of the
variance of commodity export revenues. Pieschacon (2012), employing a VAR methodology for Mexico, finds no significant relationship between oil prices and
oil production (her Fig. 2).
12
To keep our model tractable (which extends a standard sovereign default model along several dimensions), we follow most of the sovereign default
literature in making the assumption that after default the economy eventually returns to financial markets with no debt burden (Arellano, 2008; Aguiar and
Gopinath, 2006; Hatchondo et al., 2010; Mendoza and Yue, 2012). Yue (2010) introduces post-default debt renegotiation in an endowment sovereign default
model that endogenizes debt recovery rates. It is left for future research to incorporate this debt renegotiation channel in a model with commodity revenues to
asses the contribution of commodity prices to sovereign interest rate volatility.
assets) and take into account the endogenous probability that the government will default in the next period to determine
the price of the bond. The government takes as given the bond price function when selecting the level of debt. The consid-
eration of a stochastic discount factor is motivated by the observation that spreads in developing and emerging market
economies are higher during times of high risk aversion for international investors.
The specification we employ follows closely that of Arellano and Ramanarayanan (2012). The stochastic discount factor is
given by Mðatþ1 ; at Þ ¼ expð#t etþ1 12 #2t r2a Þ, where etþ1 is the shock to aggregate productivity and r2a is its variance. The
term #t ¼ a þ d log at depends on the state of aggregate productivity, allowing for time variation in the market price of risk.
The risk premium is generated from the interaction of the stochastic discount factor and the expected probability of default.
More explicitly, the price of the bond is determined by the following equation:
0
X 0
qðb ; a; zÞ ¼ Mða0 ; aÞ Kða0 j aÞ Cðz0 j zÞ ð1 dðb ; a0 ; z0 ÞÞ=ð1 þ rf Þ ð4Þ
fa0 ; z0 g
0
where dðb ; a0 ; z0 Þ is a function that equals one in the states where the government defaults and zero otherwise, r f is the inter-
national risk free rate at which international lenders can borrow or lend.13 Expression (5) can be rewritten as
0
q ¼ E ½M 0 ð1 d Þ ð1 þ r f Þ1 , alternatively:
q ¼ E ½M 0 E½1 d ð1 þ r f Þ1 þ Cov ðM0 ; 1 d Þ ð1 þ rf Þ1

0 0
which implies that if payoffs exhibit negative correlation with the pricing kernel, then a lower bond price q is required to
compensate investors for this risk. With positive a, then #t is positive on average, which generates negative correlation
between M and payoffs; negative shocks to productivity (which imply lower income) reduce the probability of repayment
and future prices while increasing M, and thus bond prices have to be lower to compensate the risk for the investor. Addi-
tionally, with d < 1 the risk premium has to be higher when the borrower has low income.14
2.4. Definition of equilibrium
A recursive equilibrium of this small open economy is given by: value functions v c ðb; a; zÞ; v d ða; zÞ and v ðb; a; zÞ, the

household’s policy functions for consumption and labor: c ð Þ; cd ð Þ; l ð Þ and ld ð Þ, the government’s policy functions for
0
asset/debt holdings b ðb; a; zÞ, its default decision dð Þ, government expenditure policy functions g c ð Þ and g d ð Þ (with access
to international credit markets and under default, respectively), tax rate functions sc ð Þ and sd ð Þ and a bond price function
qð Þ, such that: (i) given the government’s policy functions and the bond price function, the household’s policy functions
solve its static optimization problem, (ii) given the bond price function and the household’s policy functions, the govern-
ment’s policy functions and the value functions solve its dynamic problem, (iii) the bond price function qð Þ is determined
by the corresponding pricing equation.
3. Model mechanics
In this section we briefly discuss the intuition behind the main mechanisms of the model.15 Fig. 1 shows the default areas
as a function of debt levels, aggregate productivity and commodity prices. As is standard in these models, default is more likely
with more debt; this result follows from the property that the value of remaining in credit markets is decreasing with debt,
while the value of default is independent of debt. Additionally, default incentives are stronger with lower aggregate productivity
levels and lower commodity prices. Because of increasing and concave utility functions, net repayment is more costly when con-
sumption is low, which results in default being relatively more attractive.
Fig. 2 shows the optimal tax rates as a function of debt levels, aggregate productivity and oil price shocks. When the price
of oil is favorable the optimal tax rate is negatively correlated to the level of productivity: in states with low aggregate pro-
ductivity access to international credit markets is relatively limited (as the likelihood of default increases), and the optimal
level of the tax rate increases in order to finance government expenditures (left panel, Fig. 2). When the price of oil is less
favorable, the level of government indebtedness is key in determining the relation between the optimal tax rate with aggre-
gate productivity shocks. With a low productivity shock and at a low level of debt, the government can resort to borrowing
and reduce the distortive effect of taxation at an already negative situation for private production and consumption due to
low productivity. As indebtedness increases, the possibility of default becomes more likely, becoming more difficult for the
13
The specification we employ slightly differs from Arellano and Ramanarayan (2012) since output is an exogenous process in their model (for a related
specification see Hatchondo et al., 2012).
14
As discussed in Arellano and Ramanarayanan (2012), this is a parsimonious specification for the modelling of risk premia, which does not require the
introduction of additional state variables. In line with empirical evidence, it captures the behavior of higher sovereign debt spreads in times of high risk
aversion for international investors. Lizarazo (2013) introduces risk averse investors who trade with the emerging economy; interest rates and capital flows are
a function of fundamentals of the economy but also a function of financial wealth and risk aversion of international investors. We will consider the stochastic
discount factor in the valuation of sale options.
15
The discussion in part follows Arellano (2008) and Cuadra et al. (2010). Figures in this section are constructed with the calibrated model parameters
enumerated below.
Fig. 1. Default decision as a function of assets, productivity and oil price.
Fig. 2. Tax rate as a function of assets, productivity and oil price.
government to access borrowing in a situation of low aggregate productivity, and therefore the government has to depend
more on taxation to finance expenditures.16
The model generates a procyclical behavior of government expenditures as a result of the weak insurance role provided
by the incomplete asset market structure which results in the relative difficulty of borrowing in lower income states. The
transmission channel from government policy to private sector variables is the tax rate.17 Tax income is necessary to finance
government expenditures, but distorts the supply of labor and reduces private consumption.18 Given that tax rates are higher
with lower oil prices (see Fig. 2), oil prices will be positively correlated with non-primary production.
4. Parameters and functional specifications
In this section we discuss the predetermined parameters for the model as well as our calibration approach for Mexico.
4.1. Predetermined parameters
For setting the value of several parameters we take guidance from the literature (see Table 1). A standard value for the risk
aversion parameter r is 2. The discount parameter b is typically set between 0.95 and 0.97 for yearly specifications in business
cycle models for developing countries (Pallage and Robe, 2003), but can be well below 0.85 in annual terms if taken from
sovereign default models calibrated at a quarterly frequency (see Aguiar and Gopinath, 2006; Hatchondo et al., 2010; Yue,
2010).19 These models typically require relative impatience to generate default in equilibrium (Hatchondo and Martinez,
2009; Hatchondo et al., 2012), which has been associated to political factors, among others, in developing and emerging market
16
This mechanism is similar for a model with no oil revenues; see Cuadra et al. (2010), their Fig. 4.
17
A potential alternative financial transmission mechanism is through interest rates (for example see Tavares, 2015). We leave this alternative channel for
further research.
18
More specifically, given the specified utility function, the labor supply of the household is given by l ¼ ða=ð1 þ sÞÞ1=w .
19
Reports from the Auditoría Superior de la Federación (ASF) describe the yearly nature of the hedging strategy in the case of Mexico. We calibrate our model
in annual terms.
Table 1
Predetermined baseline parameters.
Description of parameter Parameter Value

Risk aversion r 2.00
Discount factor b 0.85
Labor elasticity w 1/2.2
Risk free interest rate rf 0.02
Financial markets re-entry probability l 1/3
Loss of aggregate productivity in default / 0.99
Stochastic discount factor parameter d 141
Stochastic discount factor parameter a 11
Autocorrelation oil price qz 0.940
Volatility oil price shocks rz 0.230
Autocorrelation aggregate productivity qa 0.900
economies. Our baseline parameterization is based on the latter approach, but we conduct robustness exercises and find that our
results are qualitatively similar (we also consider a higher discount factor of 0.95 in the welfare analysis).
Parameter w that determines labor elasticity is set equal to 0.455, while l equal to 1/3 implies than on average countries
in default return to international financial markets after 3 years (Cuadra et al., 2010). In the baseline calibration the risk free
interest rate r f is 0.02 in annual terms, an intermediate compromise value that takes into account its levels in recent years.
The values for the stochastic discount factor parameters a and d are taken from Arellano and Ramanarayanan (2012). There is
a broad range of values in the literature for the autocorrelation parameter of the aggregate productivity process Kða0 j aÞ, we
initially set qa equal to 0.90, in line with Arellano and Ramanarayanan (2012).
The persistence and volatility parameters, qz and rz respectively, for the stochastic process of oil prices are from
Borensztein et al. (2013), but we modify the AR(1) process as described below.20 As discussed by Pieschacon (2012), it is
not relevant for our purposes whether oil prices are driven by international supply or demand, as long as they are not signif-
icantly influenced by the behavior of the small open economy.
The aggregate productivity cost of default consists of a function hðaÞ such that hðaÞ ¼ a x when a 6 / a , where / is a
parameter and a is the unconditional mean of productivity. When a P / a , then hðaÞ ¼ / a x. Relative to Arellano
(2008), we introduce a parameter x, to match the ratio of debt to output in Mexico (see Table 2).21 This parameter shifts
the level of productivity during default while maintaining the shape of the original function hðaÞ. We take the value of param-
eter / from Cuadra et al. (2010) and set x to match the ratio of net debt of the public sector to output during the 20 year period
1995–2014. The assumption that a default event is associated with output loss is standard in the literature and intends to cap-
ture, in a tractable manner, disruptions in economic activity. When default is more costly, according to the efficiency loss spec-
ification, higher levels of debt are sustained in equilibrium.22
4.2. Calibration
The model is parsimonious in terms of the number of parameters we need to calibrate (Table 2). We set the value for p to
target the average tax rate, which is endogenous in our model. This parameter is the weight given to government expendi-
tures in the utility function and it governs the extent to which the government is willing to distort the economy through
taxation in order to provide this type of consumption. We make use of the estimates of the average effective tax rates on
consumption and labor income by Anton-Sarabia (2005) for Mexico: consumption tax rates are roughly between 7 and
14 percent, while labor income tax rates are between 8 and 12.5 percent. As our target we take the lower bound of the total
wedge implied by these estimates to keep the ratio of total government expenditures to output in line with the data.
20
There is no consensus in the literature with regards to the stationarity of oil prices. The stationarity of real oil prices has been supported in the
macroeconomics literature, and we follow this approach (for thorough discussions and related specifications see Bems and de Carvalho Filho, 2011; Pieschacon,
2012; Borensztein et al., 2013).
21
It is well known that sovereign default models face difficulty in jointly matching several moments related to sovereign debt and interest rates: average and
volatility of sovereign interest rate spreads, frequency of default and average debt levels (see Aguiar and Gopinath, 2006; Arellano, 2008; Hatchondo and
Martinez, 2009; Hatchondo et al., 2010; Yue, 2010; Roldan-Peña, 2012; Arellano and Ramanarayanan, 2012; Lizarazo, 2013). For example, Arellano (2008),
obtains an average ratio of debt to output of 6 percent, while Yue (2010), who introduces debt renegotiation after default obtains a debt ratio of 10 percent. We
opt, in our baseline calibration, to target the average debt level given our primary interest in evaluating how the risk generated by commodity prices affects
debt levels and fiscal policy. In the Appendix we explore an alternative specification for efficiency losses during default.
22
Mendoza and Yue (2012) propose a mechanism that generates an endogenous efficiency loss during default episodes: some imported inputs require
working capital financing and in a default episode these inputs are replaced by imperfect substitutes as both government and firms are excluded from credit
markets. Alonso-Ortiz et al. (2015) discuss how part of the sovereign-default literature coincides in setting the cost of default at a fall in aggregate productivity
of around 5 percent. They use a calibrated continuous time sovereign default model where government default may trigger a change in the regime of a
stochastic productivity process and find evidence in favor of productivity falls in the range of 3.7–5.9 percent. Furceri and Zdzienicka (2012) use an unbalanced
panel of 154 countries for 1970–2008 and estimate that debt crises reduce contemporaneous output growth by about 6 percentage points (with different
datasets and methodologies the magnitude of the effect ranges from 5 to 10 percentage points).
Table 2
Baseline calibration.
Description of parameter Parameter Value

Utility weight on govt. expenditures p 0.500
Loss of aggregate productivity in default x 0.054
Average level of govt. oil revenues (quantity) h 0.074
Probability large oil drops k 0.350
Volatility aggregate productivity shocks ra 0.005
Target statistics Data Model
Average total tax wedge 0.155 0.156
Average level govt. oil revenues/output 0.081 0.081
Volatility of consumption 3.397 3.870
Average debt/output ratio 0.252 0.247
Frequency large oil drops (per decade) See text See text
Parameter h is set to match the average ratio of government oil-related revenues to output during the period 2004–2014;
a value of 0.074 generates an average ratio of oil-revenues to total output of 0.081 (this parameter can be interpreted as
quantity). Parameter ra drives aggregate volatility in this economy, our chosen target is the volatility of consumption (logged
and detrended with the Hodrick-Prescott filter, as computed in Mendoza, 2010).
We first construct the Markov matrix Cðz0 j zÞ as a discrete approximation of an AR(1) process for oil prices following
Tauchen (1986). We then modify this matrix, with 5 grid-points, by adding probability to drops in oil prices: for the two
highest levels in z we subtract k from the probability that z remains unchanged in the following period and add this prob-
ability to the grid-point below each of these two values of z.23 We do this to increase the frequency of large drops in oil prices
and bring it closer to the data. IMF (2015) documents episodes where the rolling 12-month fall in oil prices exceeded 30 percent
(approximately a one standard deviation event): two episodes during the 1980s, two episodes during the 1990s, two episodes
during the 2000s, and one in 2015 (see their Fig. 2). With k equal to 0.35, our model simulations generate oil price falls larger
than 30 percent at an average frequency of 1.2 times per decade (we consider falls when the price of oil is at or above the uncon-
ditional mean, which we examine in our event analysis), this is conservative in terms of the frequency of large drops in the price
of oil.
5. Alternative financial instruments
We describe the introduction and specification of alternative financial instruments made available to the government.
5.1. Commodity-indexed bonds
We allow the government to issue bonds that promise to pay (in the case of no default) in the next period a coupon m 1
(which represents the fixed payment) plus ð1 mÞ z (the variable payment linked to the price of oil z). Parameter m 2 ½0; 1
determines the extent to which debt is indexed to commodity prices: in the baseline specification for bonds m equals one. A
proportion ð1 mÞ of the payment promised by the bond is indexed to the price of the commodity z. The price of the com-
modity indexed bond is now given by:
0
X 0
qz ðb ; a; zÞ ¼ Mða0 ; aÞ Kða0 j aÞ Cðz0 j zÞ fnðzÞ ð1 dz ðb ; a0 ; z0 ÞÞ=ð1 þ r f Þg
fa0 ;z0 g
where nðzÞ ¼ m þ ð1 mÞ z and dz ð Þ is the default decision when the government issues commodity indexed debt. The budget
0 0
constraint of the government is now written as g ¼ s c þ b nðzÞ qz ðb ; a; zÞ b þ x.
5.2. Sale options
In addition to the non-contingent one-period bond available in the baseline model, we introduce options that give the gov-
ernment the right to sell its commodity at a given price in period t þ 1. The budget constraint can be written as
0 0 0
g ¼ s c þ w qðb ; a; zÞ b kða; zÞ, where total wealth w0 in period t þ 1 is given by the sum of oil revenues x0 and debt b . 24
0 0
The introduction of sale options imply that oil revenues are given by x ¼ h maxfz ; sðzÞg, where h is the constant quantity pro-
duced of the commodity. The derivative gives the government the option to sell at the maximum between spot price z0 and a
predetermined strike price sðzÞ. The strike price is set one period in advance, as the price for period t þ 1 that is expected at
23
For example, Cðz5 j z5 Þ is the transition probability that the price of oil remains at its highest level z5 , according to the method by Tauchen (1986) for
discretizing an AR(1) process. Then we subtract k in the final (modified) transition matrix and add this value to Cðz4 j z5 Þ.
24
We can rewrite the model in terms of wealth to avoid introducing an additional state variable (see the Appendix). The same budget constraint is used in the
case of forward selling, with a modification in how oil revenues x0 are determined (discussed in the next subsection).
Table 3
Business cycle moments: standard deviations.
Standard deviation Base No oil Indexed Forward Sale

log-detrended w/HP filter model shocks bonds sale option
Production output 0.030 0.024 0.028 0.028 0.029
Consumption 0.039 0.027 0.035 0.035 0.036
Govt. expenditures 0.084 0.039 0.070 0.066 0.074
Labor 0.027 0.019 0.024 0.024 0.025
Tax rate 0.021 0.008 0.020 0.020 0.020
Trade balance/total output 0.010 0.009 0.022 0.021 0.014
P
the time that the contract is signed sðzÞ ¼ fz0 g Cðz0 j zÞ z0 . The cost kða; zÞ of the derivative is given by the expected discounted cash
flow, valued with the stochastic discount factor previously described.25 With partial hedging oil revenues are given by
x0 ¼ h ðn z0 þ ð1 nÞ maxfz0 ; sðzÞgÞ, where parameter n determines the extent to which options are used to cover oil revenues:
n equal to one implies that derivatives are not used and n equal to zero implies full coverage (the cost of the option is adjusted
accordingly).
5.3. Forward sales
In addition to the non-contingent one-period bond available in the baseline model, we allow the government to set the
price for its commodity one year in advance, following Borensztein et al. (2013). This works as follows: if the spot price of oil
in period t is z, oil revenues in period t þ 1 will be given by sðzÞ h, where h is the constant quantity produced of the com-
modity. The price sðzÞ is set as the expected value for period t þ 1 with the information that is known at period t, written as
P
sðzÞ ¼ fz0 g Cðz0 j zÞ z0 , which is the expected value of z0 in period t, when z is known.26 The budget constraint is written in the
same manner as in the case for sale options. As in the case of sale options, it is assumed initially that these contracts are avail-
able during default episodes.27
6. Quantitative analysis
The objective is to provide a quantitative analysis of the consequences of using different financial derivatives that con-
tribute to moderate the fluctuations of commodity revenues and their impact on the economy. We document how business
cycle moments are modified with the introduction of new financial instruments. In particular, we document a reduction in
the volatility of different macroeconomic variables, their correlation with the price of oil and the correlation of government
expenditures with the business cycle. We then conduct an event analysis centered on episodes when there are large drops in
commodity prices and compare the evolution of the baseline economy with an economy where the government uses differ-
ent financial derivatives. In our welfare analysis we allow for the possibility of partial indexation and hedging.28
6.1. Business cycle statistics
Tables 3–5 document the key business cycle statistics of the model under different scenarios. In addition to allowing the
government to access different types of financial instruments we can recreate a scenario, starting from the baseline speci-
fication, where we eliminate the volatility of oil revenues. This exercise provides a benchmark in terms of the overall impact
of oil-revenue volatility in the model economy (e.g., the amount of volatility that it generates in other macroeconomic vari-
ables, see Table 3).29 It establishes the scenario where oil-revenue volatility is completely eliminated. For example, eliminating
volatility in oil-revenues reduces the volatility in private consumption from 0.039 to 0.027.30 The effect on government expen-
ditures is more pronounced as its volatility decreases from 0.084 to 0.039 (Table 3).
25
It was not possible to consider alternative valuation methods, such as a binomial model. We show below that for the baseline calibration, this instrument
provides the lowest welfare gains in the baseline calibration, so we are not overestimating its relative advantage.
26
It is straightforward to prove that, assuming an AR(1) process, the variance of sðzÞ is lower than the variance of z.
27
This will result, in our baseline calibration, in lower average debt levels sustained in equilibrium and more conservative conditional welfare gains as we
discuss below, but no significant differences in terms of business cycle moments.
28
In terms of business cycle moments and event analysis, partial indexation and hedging simply moderate the impact on the different macroeconomic
variables relative to the full indexation or hedging case.
29
For this exercise we adjust parameter h so that the average of commodity revenues is the same as in the baseline specification.
30
Schmitt-Grohé and Uribe (2015) estimate that terms of trade shocks account for approximately 12 percent of consumption volatility and 17 percent of
output volatility in the case of Mexico (their Table 2). Pieschacon (2012), also for the case of Mexico, estimates that oil price shocks account for 21.3 percent of
the variance of consumption at a 4-quarter horizon (her Table 1), while the shares are 12.5 and 16.8 percent, respectively, for tradable and non-tradable output.
The proportions of volatility of consumption and production (non-oil) output explained by oil shocks in our model, approximately 29 and 22 percent, are
somewhat higher but comparable to these empirical estimates.
Table 4
Business cycle moments: correlations.
Correlation Base No oil Indexed Forward Sale

log-detrended w/HP filter model shocks bonds sale option
Oil price and tax rate 0.795 – 0.323 0.453 0.700
Oil price and govt. exp. 0.859 – 0.265 0.435 0.713
Oil price and consumption 0.674 – 0.233 0.437 0.578
Oil price and prod. output 0.599 – 0.192 0.368 0.507
Govt. exp. and total output 0.932 0.914 0.707 0.800 0.892
Govt. exp. and consumption 0.833 0.934 0.761 0.863 0.820
Tax rate and prod. output 0.799 0.669 0.700 0.762 0.783
Tax rate and total output 0.879 0.669 0.670 0.742 0.850
Prod. output and int. rate 0.234 0.272 0.206 0.261 0.235
Table 5
Business cycle moments: averages.
Average (levels) Base No oil Indexed Forward Sale

model shocks bonds sale option
Government expenditures 0.159 0.159 0.160 0.159 0.159
Private consumption 0.628 0.630 0.630 0.630 0.629
Tax rate 0.156 0.155 0.154 0.155 0.156
Debt/total output ratio 0.247 0.238 0.164 0.235 0.238
The comparison with the alternative scenarios makes explicit the fact that although financial instruments can reduce the
volatility of macroeconomic variables they cannot, as would be expected, completely eliminate the volatility induced by fluc-
tuations in oil-revenues. Among the different financial instruments, we find that forward-selling is most effective in reducing
volatility for different the macroeconomic variables. The use of sale options has the lowest effect in reducing volatility as
their utilization reduces the impact of downward fluctuations, while they have no effect when spot prices are higher than
the predetermined strike price of the option. The increased volatility in the trade balance, with the new financial instru-
ments, reflects the ability to exploit access to international financial markets to smooth expenditures (this is further dis-
cussed below).
The baseline model delivers a strong negative correlation between oil prices and the tax rate and strong positive corre-
lation between oil prices and government expenditures. When the price of oil falls, the government increases tax rates to
finance government expenditures, given that taxation is distortionary it will also find optimal to adjust government expen-
ditures (Table 4).31 The negative correlation between the tax rate and production output results in part from its distortionary
effect on labor supply and from the higher tax rates during periods of low aggregate productivity (see the discussion of tax-rate
policy functions in Section 3). Comparing the impact of different financial instruments, indexed bonds are most effective in
reducing the correlation of different macroeconomic variables with the price of oil. Furthermore, indexed bonds are most effec-
tive in reducing the correlation of government expenditures with total output and private consumption.
In addition to the consequences in terms of the correlations and volatilities of the different variables in the model, the
introduction of the alternative financial instruments has an effect on their average values in the stochastic steady state
(Table 5). In particular, in some cases there is a slight increase in average consumption and government expenditures as well
as a reduction in the average tax rate. These results are driven, in our baseline parameterization, by the fact that lower aver-
age debt levels are sustained in the new stochastic steady states, where sustainable levels of debt are determined by the
incentives to default. The difference is most significant and natural for indexed bonds. The introduction of indexed debt
reverses the incentives to default with respect to the price of oil: in the baseline specification the government has an incen-
tive to default when the price of oil is low (as discussed in Section 3). With indexed debt the incentives to default become
stronger with a higher price of oil, which is associated with larger debt payments.32 Given these increased incentives to
default, the government is able to sustain lower average levels of debt, this implies that lower average tax rates are needed
and that more resources can be used for public expenditures (the lower tax rate is associated with higher private
consumption).33
31
The procyclicality of tax rates and public expenditures is already present in sovereign default models without commodity-revenues (Cuadra et al., 2010;
Hatchondo et al., 2012): adverse aggregate productivity shocks increase the likelihood of default, international investors are less willing to lend making
government expenditures and private consumption positively correlated with output. A similar intuition applies with commodity-revenues in our model. The
correlation between tax changes and total output in our model is 0.46, close to the correlation estimated for Mexico by Vegh and Vuletin (2012). In their data,
this correlation is driven by value added tax rates (see their Figs. 13 and 14). Using the tax-rate data from Anton-Sarabia (2005) for Mexico, for the period 1993–
2001 for which different measures of both effective tax rates on consumption and labor income are available, the standard deviation of the sum (represented by
the total tax rate in our model), is between 0.013 and 0.022, compared to 0.021 in our baseline model.
32
We can observe how the area of default becomes larger for high oil prices as we increment the level of debt indexation, eventually it becomes larger than
the area of default with low oil prices.
33
We discuss the welfare implications of this result below, contrasting the welfare results in the new stochastic steady state with those that consider the
transition.
The introduction of derivatives implies a welfare gain both in autarky and with access to international financial mar-
kets.34 The lower average debt levels sustained with derivatives in our baseline parameterization can be explained by the fact
that they allow to partially smooth the shocks in autarky (relative to the baseline situation where no instruments of any kind are
available), compared to the situation with access to financial debt markets where the government already has an instrument
available and the marginal gain generated by an additional instrument is relatively smaller.35 In other words, autarky becomes
a relatively less costly situation and incentives to default are then relatively stronger, reducing the average levels of debt the
government is able to sustain (a similar intuition applies to the case with no oil shocks). Additionally, we find that the welfare
gains associated with forwards during autarky, relative to the situation with access to financial markets, are higher than with
options.36 This implies that default is relatively less costly with forward sales than with sale options, therefore the average
levels of debt that the government is able to sustain are lower (although this difference of 0.235 vs. 0.238 is rather small,
Table 5).
6.2. Event analysis: large drops in oil prices
Next we document how the economy reacts to commodity price fluctuations under different scenarios in terms of access
to financial instruments. In particular, we simulate the alternative versions of our model and register the evolution of the
main macroeconomic variables in front of drops in the price of oil that are larger than 30 percent when the price of oil is
equal or above its unconditional mean.
The comparison of the baseline model and the model with forward-selling is shown in Fig. 3. With an average fall in the
price of oil of 50 percent, the government increases the tax rate by approximately 2 percentage points in the baseline sce-
nario and reduces government expenditures by 14.7 percent.37 The increase in the tax rate translates directly into lower labor,
production output and consumption. The use of forward-selling allows the government to smooth the adjustment in tax rates
and government expenditures, resulting also in a smoother behavior for consumption, labor and production output. In the base-
line scenario, the government slightly increases debt with a fall in oil prices (becomes more negative), while with forward-
selling the government foresees a lower level of commodity revenues in the next period (the hedging strategy implies that
the fall in oil revenues generated by the drop in oil prices is postponed one period), and therefore initially reduces the debt
level.38 The ability of the government to increase debt is determined by the level of debt at the time of the shock; if it occurs
when the debt level is relatively low there is more margin to increase debt (not reported).
In Fig. 4 we compare the distribution of the percentage falls in consumption and government expenditures to contrast the
likelihood of very negative events; the probability of large drops in both variables is higher in the baseline scenario. With
access to sale-options the results are similar in terms of the ability of the government to smooth the evolution of the main
macroeconomic variables (Fig. 5). Additionally, upon the drop in oil prices, the government also chooses to slightly reduce
debt. With indexed bonds however, the fall in oil-revenues has the same timing as in the baseline scenario (last panel, Fig. 6),
and in both situations the government increases debt slightly. The increase in the volatility of the trade balance reflects the
increased capacity for the government to smooth expenditures.39
6.3. Partial bond indexation
0 0
With commodity-indexed bonds the budget constraint of the government is written as g ¼ s c þ b nðzÞ qz ðb ; a; zÞ b þ x,
where nðzÞ ¼ m þ ð1 mÞ z. Parameter m 2 ½0; 1 determines the extent to which debt is indexed to commodity prices: a pro-
portion ð1 mÞ of the payment promised by the bond is indexed to the price of the commodity z. The price of these bonds is
0
given by qz ðb ; a; zÞ, as previously described.40
34
We assume that contracts are available during periods of exclusion from debt markets. In an alternative version of the model with forward sales we assume
the government jointly defaults on debt and this derivative (the government would never default on an option, it can simply select not to execute it), in this
scenario there will be incentives to renege on debt and forward sales in situations where the hedging strategy results in a very negative payoff and debt is large.
However, the temporary autarky situation is more costly if derivatives are not available. Results with the alternative assumption are available upon request, in
terms of business cycle implications the differences are negligible.
35
On the other hand, reducing uncertainty may work in the opposite direction: for example, eliminating fluctuations both in the price of oil and in production
efficiency results in higher average debt levels (and no default since there are no shocks) of approximately 4 percentage points of total output. In our welfare
analysis we consider an alternative parameterization with a higher discount parameter and find that this effect dominates, and the introduction of forward
sales leads to (marginally) higher average levels of debt.
36
We can verify this argument by introducing derivatives in the baseline model and compare welfare in autarky when l (the probability of returning to
financial markets) is zero. We find that welfare with forward sales is higher in permanent autarky than with sale options.
37
Exploiting a VAR methodology for the case of Mexico, Pieschacon (2012) estimates that for a 20 percent quarterly increase in the price of oil, private
consumption increases as much as 2 percent, while government expenditures increase by almost 4 percent (Fig. 2 in Pieschacon, 2012). These results are
slightly more moderate but comparable in magnitude with our baseline annual model, with average falls of 5.6 percent in consumption and 14.7 in government
expenditures in front an average oil-price drop of 50 percent.
38
Note the timing notation for the asset variable in our model. Given our calibration procedure, as previously discussed, there are not significant movements
in interest rates. This is further discussed in the Appendix.
39
For a discussion of a similar result with GDP-indexed bonds see Hatchondo and Martinez (2012).
40
Here we illustrate the mechanisms behind debt indexation. In our welfare analysis we allow for the possibility of partial indexation as well as partial
hedging with derivatives. Partial hedging generates more modest results (in a monotonic manner) in terms of reducing volatility in macroeconomic variables
and their correlation with oil prices relative to full hedging (the intuition is straightforward).
Fig. 3. Baseline and forward selling models.
Fig. 4. Changes in consumption and govt. expenditures generated by the fall in oil prices.
0 0
We can rewrite the budget constraint as g s c þ qz ðb ; a; zÞ b ¼ b nðzÞ þ x, where the left hand side of the expression
includes control variables in any given period, while the terms on the right hand side b nðzÞ þ x, which include oil revenues
plus debt payments, are predetermined or depend on the exogenous price of oil z in every period. In Fig. 7B we graph, as a
function of the level of indexation, the standard deviation of the interest rate in the left panel, and the standard deviation of
oil revenues plus debt payments in the right panel. We observe that indexation can generate a significant increase in the
volatility of bond prices, inherited from the high volatility in commodity prices. Fluctuations in oil revenues, however, are
Fig. 5. Baseline and option selling models.
Fig. 6. Baseline and indexed bond models.
offset by payments on indexed bonds generating a reduction in the volatility of the total sources of financing directly linked
to the price of oil. Due to the fall in volatility of the total sources of financing linked to oil prices, there is a reduction in the
volatility of private consumption and government expenditures, as well as in the correlation of the tax rate and government
expenditures with oil prices (see Fig. 7A).
6.4. Welfare analysis
In standard business cycle models featuring a representative household with risk averse preferences, the inability to
insure against fluctuations in aggregate consumption implies a loss in welfare.41 These welfare losses however are not quan-
41
This brief discussion partially builds on Pallage and Robe (2003).
Fig. 7. Properties of indexed bond model.
titatively large in a representative agent framework. For the U.S., eliminating fluctuations in the cyclical component of aggregate
consumption is equivalent to giving the representative household an increase of consumption of less than 0.1 percent across all
dates and states of the world. Pallage and Robe (2003) estimate that removing consumption volatility in the least developed
countries is equivalent to increasing consumption by approximately 0.3 percent in perpetuity.42 As sometimes stressed in
the literature, estimates of the welfare costs of economic fluctuations should not be considered in absolute terms. For example,
welfare losses are larger when we consider idiosyncratic shocks and liquidity constraints faced by individuals over the business
cycle rather than a representative household.
With these caveats in mind we conduct a welfare analysis for all instruments under different versions of the model and
using two measures of welfare (defined and explained below).43 In addition to the baseline model, we consider an alternative
parameterization with a higher discount factor. We also consider a model without sovereign default, where the debt limit is set
exogenously.
42
These results are based on the median welfare computations considering the observed volatility of consumption for a set of African economies and a risk
aversion parameter of 2.5 (basic model, Table 2).
43
We follow Schmitt-Grohé and Uribe (2007) in our definitions for analyzing welfare.
6.4.1. Conditional welfare analysis

We first define welfare associated with the time-invariant stochastic allocation in the baseline model conditional on a
particular initial state of the economy in period zero as:
" #
X
1
vb ¼ E0
b
bt uðcbt ; g bt ; 1 lt Þ
t¼0
b
where cbt ; g bt and lt denote the equilibrium contingent allocations for private consumption, government expenditures and
labor in the baseline specification of our model, where only non-contingent debt is available.
In the same manner, the welfare conditional on an initial state of the economy in period zero, under an alternative sce-
nario is given by (with its corresponding equilibrium contingent allocations):
" #
X
1
v a ¼ E0 a
bt uðcat ; g at ; 1 lt Þ
t¼0
At period zero we set the initial level of assets as the median of the stochastic steady state in the baseline model (this is our
point of reference to evaluate the introduction of different financial instruments), while oil prices and aggregate productivity
are at their mid-levels.44
Let c denote the welfare gain of adopting a new financial instrument conditional on the initial state of the economy. This
value is defined as the increment in the two consumption goods in all expected future states of the baseline economy such
that the representative household is indifferent between the baseline economy and the alternative economy (with access to
additional financial instruments):
" #
X
1
va ¼ E0 t b
b uðð1 þ cÞ ct ; ð1 þ cÞ g t ; 1 lt Þ
b b
t¼0
Thus c is defined as the value that implies this indifference.
6.4.2. Unconditional welfare analysis

Next we define D as the unconditional welfare gain of introducing an alternative or additional financial instrument,
formally:
" #
X
1
E ½v a ¼ E
b
bt uðð1 þ DÞ cbt ; ð1 þ DÞ g bt ; 1 lt Þ
t¼0
This measure considers the expected welfare, where expectations are with respect to the ergodic distribution of the variables
in the stochastic steady state. This measure does not take into account the transition towards the new stochastic steady state
(this is done by the conditional welfare measure). This difference is relevant since, as we have shown previously, the intro-
duction of alternative financial instruments can affect the average levels of debt that are sustained in equilibrium. In partic-
ular, if the government has to reduce its average levels of debt during the transition (initially this will be associated with
higher average tax rates) this will imply a potential reduction of the welfare gains, whereas if the government is able to
increase levels of debt then there is an additional potential gain in welfare.
6.4.3. Welfare results

Table 6A reports, for the baseline model and calibration, the optimal level of hedging or indexation according to the con-
ditional welfare criteria as well as the unconditional welfare gain associated with this particular level. In the case of forward
sales, for example, full hedging is optimal while only a small amount of indexation is optimal.45 From an unconditional welfare
perspective, in all cases full hedging and indexation generate the largest gains in the new stochastic steady states. However, in
the case of indexed bonds full indexation would imply that the government needs to considerably reduce average levels of debt,
as reported in Table 5, which actually generates a welfare loss if we consider the transition. Nevertheless, at the optimal level of
debt indexation of 1/10, the negative effects generated by the fact that the government has to reduce average debt levels are
slightly outweighed by the gains from the reduction in volatility.46 In the case of sale options, the costs associated with this
derivative also contribute to reduce the welfare gains.
44
Here we depart from Schmitt-Grohé and Uribe (2007), who use the non-stochastic steady state as the initial state of the economy. In our model the non-
stochastic steady state is not the most relevant point of reference, we want to evaluate the welfare gains for a government that faces uncertainty and decides to
implement a hedging or indexation strategy, in this sense we are in line with Borensztein et al. (2013). Furthermore, the level of assets in the non-stochastic
steady state could imply default in the stochastic model. Additionally, we depart from Schmitt-Grohé and Uribe (2007) in that we have to consider two
consumption goods.
45
Partial indexation implies that the volatility of the different variables will not be reduced to the levels reported in Table 3. For example, the volatility of
government expenditures with 10 percent indexation is 0.080 compared to 0.070 with full indexation.
46
With this rate of indexation average debt levels are reduced by less than 1/10 of a percentage point relative to total output.
Table 6A
Conditional and unconditional welfare analysis.
Baseline calibration Indexed Forward Sale

low discount factor ðb ¼ 0:85Þ bonds sale option
Optimal indexation/hedging 0.10 1.00 0.00
Conditional welfare ð1 þ cÞ 1.0001 1.0007 –
Unconditional welfare ð1 þ DÞ 1.0008 1.0035 –
Table 6B
Alternative calibration Indexed Forward Sale

high discount factor ðb ¼ 0:95Þ bonds sale option
Conditional welfare ð1 þ cÞ 1.0005 1.0029 1.0010
Unconditional welfare ð1 þ DÞ 1.0009 1.0021 1.0013
Table 6C
Alternative model Indexed Forward Sale

exogenous debt limit ðb ¼ 0:95Þ bonds sale option
Conditional welfare ð1 þ cÞ 1.0036 1.0028 1.0010
Unconditional welfare ð1 þ DÞ 1.0045 1.0018 1.0009
We also consider an alternative calibration of the baseline model with a discount factor of 0.95, more in accordance with
values in the standard business cycle literature (Table 6B).47 Relative to the baseline calibration, from a conditional welfare
perspective a higher discount factor gives more weight to the gains in the new stochastic steady state and the optimal levels
of indexation and hedging are higher and the conditional welfare gains are larger.
Finally, we report the results for a version of the model with an exogenous debt limit. We set the exogenous debt limit
equal to the largest level of debt observed in the baseline model, then we set the efficiency cost of default parameter x equal
to a large number, so that default does not occur in equilibrium. For this version of the model we also use a higher discount
factor of 0.95 as it is no longer a sovereign default model. The most significant difference relative to the results of the sover-
eign default model with high discount factor are for the indexed bonds (Table 6C). This instrument had the most important
impact on the sustained average levels of debt in the model with sovereign default (Table 5), whereas in the model with an
exogenous debt limit this mechanism no longer comes into play (this effect had a negative impact on welfare as it forced the
government to reduce the amount of debt). Thus, in the version of the model with an exogenous debt limit full indexation
becomes optimal, associated with larger welfare gains as indexed debt is the most effective in reducing the volatility of gov-
ernment expenditures, private consumption and labor.
Note that our specification for an exogenous debt limit is different from the one analyzed by Borensztein et al. (2015). In
the baseline version of their model insurance may allow the country to considerably increase the level of borrowing; the
country can issue non-defaultable debt subject to a limit on the fraction of its output that it can pledge in repayment to for-
eign lenders. They find that introducing bonds that provide insurance against natural disasters allows the country to increase
its external borrowing from approximately 30 percent of GDP to more than 60 percent of GDP (this results in a substantial
conditional welfare gain).48 The welfare gains in their model decrease with the discount factor, because most of the welfare
gains come from relaxing the borrowing constraint and these gains are reduced when the consumer is more patient. In an alter-
native version of their model where default is possible the welfare gains are reduced to those generated by the insurance chan-
nel (which represent a fraction of a percentage point of annual consumption), since the new instrument has a relatively small
impact on the default threshold (they provide a discussion of why it is not definitive a priori how the introduction of the new
instrument affects the borrowing constraint for non-contingent debt).
47
To maintain the average debt levels of the baseline calibration we need to increase the efficiency cost of default parameter x to 0.075, this is in the upper
part of the range of the costs generally estimated in the sovereign default literature. Average debt levels as a ratio over total output are 1 percentage point
higher with forward sales, this accounts for conditional welfare gains being bigger than unconditional welfare gains. Welfare gains will, of course, also depend
on the relevance of commodity revenues and their volatility.
48
This result is similar in Borensztein et al. (2013); introducing the possibility of hedging against commodity price fluctuations allows an increment of debt
from zero to 80 percent of income. This result generates the largest conditional welfare gains. However, they discuss how if the model is interpreted as one with
overlapping generations and altruistic (but impatient) parents, introducing the possibility of hedging increases the welfare of current generations at the cost of
future generations.
7. Conclusion
We have analyzed a sovereign default model with endogenous fiscal policy to evaluate the macroeconomic consequences
of using financial derivatives and commodity-indexed bonds to moderate the impact of fluctuations in commodity-related
government revenues. We have documented how these instruments reduce the volatility of the different macroeconomic
variables as well as their correlation with commodity prices.
Different instruments offer different trade-offs in terms of costs and benefits. An advantage of commodity linked bonds
over futures contracts is that futures contracts may have relatively limited maturities available, whereas bonds can, in prin-
ciple, be issued at longer-term maturities (Atta-Mensah, 2004; Daniel, 2001). The benefits of indexed debt, however, may be
offset by significant fixed costs of setting up a market for a new debt product (Sandleris and Wright, 2013) as well as the
possibility of being subject to low liquidity. Additionally, the use of derivatives may entail political costs if interpreted as
speculative by the public. It has been suggested that international financial institutions may contribute to their use by pro-
moting awareness and supporting risk management practices (Daniel, 2001; Caballero and Panageas, 2008).49 However,
investors and sovereign debtors may consider that existing markets for futures and options provide sufficient opportunities
for insurance against commodity price fluctuations while financial innovation may encounter many potential obstacles (see
Borensztein and Mauro, 2004).
There are several potentially interesting research possibilities for these issues. Hatchondo et al. (2012) exploit a sovereign
default model to analyze the benefits of implementing a debt ceiling rule and demonstrate that lower debt levels allow the
government to implement a less procyclical fiscal policy that reduces aggregate consumption volatility. Aguilar and Ramirez
(2013), Kumhof and Laxton (2013), Medina and Soto (2007), Pieschacon (2012) and Snudden (2013) evaluate the implica-
tions of different fiscal policy rules in models that incorporate the effect of commodity price fluctuations on public finances.
Introducing the possibility of accumulating international reserves, or sovereign wealth funds, could provide quantitative
guidance to the claim that the use of hedging instruments reduces the cost of opportunity implied by these assets and
the possibility of evaluating other potential trade-offs.50 Additional work is also necessary to study alternative transmission
mechanisms from commodity price fluctuations to private sector production.51 We leave these topics for future research.
Appendix A
A.1. Model in terms of wealth
We can rewrite the model in terms of a new state variable w, total wealth. This is useful since in the case of forward-
selling, for example, we do not need to keep the contract price set in the previous period as an additional state variable. With
access to financial markets, the dynamic problem can now be written as follows:
X
v c ðw; a; zÞ ¼ f max 0
g; w ; sg

uðc ; g; 1 l Þ þ b Kða0 j aÞ Cðz0 j zÞ v ðw0 ; a0 ; z0 Þ
fa0 ; z0 g

subject to the optimal household functions fc ð Þ; l ð Þg. The government budget constraint is g ¼ s c þ w qð Þ ðw0 x0 Þ,
0
where w0 ¼ b þ x0 is total wealth in the next period (assets, or debt, plus oil-revenues). With forward-selling, for example,
P
oil revenues x0 are known one period in advance and given by x0 ¼ h fz0 g Cðz0 j zÞ z0 .
When the government defaults its budget constraint becomes g ¼ s c þ w, where now we have w0 ¼ x0 , the dynamic prob-
lem of the government is given by:
X
v d ðw; a; zÞ ¼ max
fg; sg

uðcd ; g; 1 ld Þ þ b Kð Þ Cð Þ fl v ðw0 ; Þ þ ð1 lÞ v d ðw0 ; Þ g
fa0 ; z0 g
49
A possible concern is that investors may influence prices in financial markets. Fattouh et al. (2012) review the literature on the role of speculation in oil
markets and find that the existing evidence is not supportive of an important role of financial speculation in driving the spot price of oil after 2003. Instead, they
consider that there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the
financialization of oil futures markets. Knittel and Pindyck (2013) support the view that speculation had little, if any, effects on prices and volatility. Kilian and
Murphy (2014) argue that the surge in oil prices during 2003–2008 was mainly driven by unexpected increases in world oil consumption, although speculative
demand shifts may have played an important role during earlier price shock episodes in 1979, 1986 and 1990. Juvenal and Petrella (2015), on the other hand,
argue that even though the recent oil price increase was mainly driven by global demand, the financialization process of commodity markets also played a role.
We stress that the key assumption in our framework is that the behavior of commodity prices are taken as given by the small open economy.
50
van der Ploeg (2014) makes the case that a country managing natural resource wealth should establish three funds: an intergenerational sovereign wealth
fund to smooth consumption across generations, a liquidity fund to deal with commodity price volatility, and an investment fund to control spending on
domestic investment. Bianchi et al. (2014) extend a dynamic model of sovereign default with sudden-stop shocks in which the government faces the trade-off
between the insurance benefits of reserves and the cost of keeping larger gross debt positions. Some of the extensions discussed would increase the
computational burden in our model, given the additional endogenous state variable. We have abstracted from the impact of commodity prices on real exchange
rates; Aizenman et al. (2012) find an important role for international reserves in stabilizing the real exchange rate in the presence of large commodity terms of
trade shocks. Kohlscheen and O’Connell (2015) construct a default model with international reserves and credit; international reserves can provide an interim
source of trade finance during periods of debt distress.
51
Fernandez et al. (2015) and Shousha (2016) emphasize working capital requirements in the private sector as the financial channel through which
fluctuations in interest rates are transmitted to the private sector. For the specification of this constraint see Neumeyer and Perri (2005).

subject to the budget constraint under default and the optimal decisions of the household fcd ð Þ; ld ð Þg when there are no
access to international credit markets.
A.2. Numerical solution algorithm and computation of moments
The numerical solution algorithm is standard in the literature (see for example Aguiar and Gopinath, 2006; Arellano,
2008; Hatchondo et al., 2012). We describe it for the baseline model (grid sizes and the definition of state variables may
change across model specifications).
Assume an initial price function qð Þ (a simple set of initial values is defined by the inverse of the risk free interest rate),
value functions v c ðb; a; zÞ and v d ða; zÞ and a default set (e.g. start with no default over the state space). Assets are defined
on a grid with 240 points, aggregate productivity and commodity prices are defined on 5 point grids each, constructed
following Tauchen (1986), and modified in the case of oil prices as described in the calibration section.
0
The main decision variables for the government are the tax rate sðb; a; zÞ and next-period assets b ðb; a; zÞ, both are func-
tions of the state variables ðb; a; zÞ (tax rates are defined on a grid with 7 points between 0.12 and 0.18).52 For each point
0
ðb; a; zÞ and for every possible value of s and b , we obtain cð Þ and lð Þ using the first order condition of the representative
household and its budget constraint, then obtain gð Þ from the government budget constraint, compute utility values and
0
value functions. For every point ðb; a; zÞ retrieve the optimal tax rate s, policy function b and the new default set dð Þ. Update
value functions.
Given the new default set recompute the bond price function.
At this point policy function iteration is employed to accelerate convergence in the value function (the outer loop consists
of value function iteration, the improvement in terms of convergence time is considerable as is typically expected).
Return to the second step, and repeat until value function convergence is achieved (up to a determined tolerance level).
To compute the model generated moments, for each specification we simulate the model 1,000 times, with 500 periods
for each simulation. The first 100 periods in each simulation are dropped to eliminate dependence of the results on the initial
conditions (initial conditions can be arbitrary if this procedure is followed). Detrended variables (in logs) are computed
employing an HP filter with a parameter value of 100. For welfare calculations we simulate the model 250 thousand times
for each parameterization (conditional welfare values are verified with the value function solution).
A.3. Alternative productivity loss specification during default
In our baseline specification the aggregate productivity cost of default consists of a function hðaÞ such that hðaÞ ¼ a x
when a 6 / a , where / is a parameter and a is the unconditional mean of aggregate productivity. When a P / a , then
hðaÞ ¼ / a x. Relative to Arellano (2008), we have introduced a parameter x, to match the ratio of debt to output in Mexico
(see Table 2). This parameter shifts the level of productivity during default while maintaining the shape of the original func-
tion hðaÞ. We take the value of parameter / from Cuadra et al. (2010) and set x to match the ratio of public sector debt to
total output for Mexico. In Fig. A1 we plot the resulting productivity during default under our baseline specification.
It is well established in the literature that sovereign default models face difficulty in jointly matching several moments
related to sovereign debt and interest rates: average and volatility of sovereign interest rate spreads, frequency of default and
average debt levels (see Aguiar and Gopinath, 2006; Arellano, 2008; Hatchondo and Martinez, 2009; Hatchondo et al., 2010;
Yue, 2010; Roldan-Peña, 2012; Arellano and Ramanarayanan, 2012; Lizarazo, 2013; and the discussion in Mendoza and Yue,
2012). In the baseline calibration our target is the average debt level, given our primary interest in evaluating how the risk
generated by commodity prices affects the possibility of the government to finance its expenditures. The volatility of interest
rates, however, is limited at 0.003 while the average spread is 6 basis points. This volatility is limited even with the intro-
duction of a stochastic discount factor based on Arellano and Ramanarayanan (2012). Given the annual calibration of our
model, the volatility of the aggregate productivity process is considerably smaller than their value for a quarterly calibration
with exogenous output, 0.005 compared to 0.017. The volatility of the stochastic discount factor, and its impact on sovereign
interest rates, is determined by this parameter.53
Alternatively, we can consider a specification where productivity losses are convex-shaped (see Fig. A1). Under the alter-
native specification, aggregate productivity in default is given by the function adef ¼ maxf0:92 a3:8 cred ; 0:9239g, where the
lower bound 0.9239 is set to match the lowest level of aggregate productivity under the baseline specification (see
Fig. A1), the value 3.8 generates the convex shape of productivity under default and increases interest rate volatility (differ-
ent values are possible). Under this specification the efficiency cost of default is an increasing, convex function of productiv-
52
Robustness exercises were conducted using a grid of 14 points for the tax rate, with no relevant differences in the results.
53
Hatchondo et al. (2010) evaluate different algorithms to solve the models of Arellano (2008) and Aguiar and Gopinath (2006) and show the limited capacity
for these models to generate volatility in interest rates with realistic mean levels of debt to output ratios. In particular, our results are in line with the low
interest rate volatility in their solution of the model by Aguiar and Gopinath (2006) without trend shocks (see their Table 3). The model with shocks to the trend
in aggregate productivity increases volatility of interest rates, although still at very low levels, but results in positive correlation of interest rates and output (see
Table 3 in Hatchondo et al., 2010).
Fig. A1. Alternative productivity losses during default.
ity, thus introducing in a reduced form manner the mechanism studied by Mendoza and Yue (2012). The volatility of interest
rates is 0.02 and average spreads are increased to 56 basis points. However, one notable drawback is that by making default
relatively less costly when the level of productivity is high (compared to the baseline specification), default becomes rela-
tively more attractive during good times, and the correlation of interest rates and production (non-commodity) output is
negative but small at 0.023, compared to 0.234 in the baseline model, while the new average debt ratio is 0.164.
References
Aguiar, M., Gopinath, G., 2006. Defaultable debt, interest rates and the current account. J. Int. Econ. 69 (1), 64–83.
Aguilar, A.M., Ramirez, C., 2013. Oil-dependent Revenues and Macroeconomic Stability Under Fiscal and Monetary Rules: An Analysis for Mexico. WP.
Aizenman, J., Edwards, S., Riera-Crichton, D., 2012. Adjustment patterns to commodity terms of trade shocks: the role of exchange rate and international
reserves policies. J. Int. Money Finance 31 (8), 1990–2016.
Alonso-Ortiz, J., Colla E., Da-Rocha, J.M., 2015. The Productivity Cost of Sovereign Default: Evidence from the European Debt Crisis. WP.
Anton-Sarabia, A., 2005. Average effective tax rates in Mexico. Econ. Mexicana Nueva Época, XIV (2), 185–215.
Arellano, C., 2008. Default risk and income fluctuations in emerging economies. Am. Econ. Rev. 98 (3), 690–712.
Arellano, C., Ramanarayanan, A., 2012. Default and the maturity structure in sovereign bonds. J. Polit. Econ. 120 (2), 187–232.
Atta-Mensah, J., 2004. Commodity-Linked Bonds: A Potential Means for Less Developed Countries to Raise Foreign Capital. Bank of Canada WP 2004-20.
Bems, R., de Carvalho Filho, I., 2011. The current account and precautionary savings for exporters of exhaustible resources. J. Int. Econ. 84 (1), 48–64.
Bianchi, J., Hatchondo, J.C., Martinez, L., 2014. International Reserves and Rollover Risk. WP.
Borensztein, E., Cavallo, E., Jeanne, O., 2015. The Welfare Gains from Macro-Insurance Against Natural Disasters. NBER WP 21674.
Borensztein, E., Jeanne, O., Sandri, D., 2013. Macro-hedging for commodity exporters. J. Develop. Econ. 101, 105–116.
Borensztein, E., Mauro, P., 2004. The case for GDP-indexed bonds. Econ. Policy 19, 165–216.
Caballero, R.J., Panageas, S., 2008. Hedging sudden stops and precautionary contractions. J. Develop. Econ. 85, 28–57.
Cespedes, L.F., Velasco, A., 2014. Was this time different?: fiscal policy in commodity republics. J. Develop. Econ. 106, 92–106.
Cuadra, G., Sanchez, J.M., Sapriza, H., 2010. Fiscal policy and default risk in emerging markets. Rev. Econ. Dynam. 13 (2), 452–469.
Daniel, J.A., 2001. Hedging Government Oil Price Risk. IMF WP/01/185.
Durdu, C.B., 2009. Quantitative implications of indexed bonds in small open economies. J. Econ. Dynam. Control 33, 883–902.
Eaton, J., Gersovitz, M., 1981. Debt with potential repudiation: theoretical and empirical analysis. Rev. Econ. Stud. 48 (2), 289–309.
Fattouh, B., Kilian, L., Mahadeva, L., 2012. The Role of Speculation in Oil Markets: What Have We Learned So Far? WP.
Fernandez, A., Gonzalez, A., Rodriguez, D., 2015. Sharing a Ride on the Commodities Roller Coaster: Common Factors in Business Cycles of Emerging
Economies. Borradores de Economía, N. 915-2015, Banco de la República de Colombia.
Frankel, J.A., Vegh, C.A., Vuletin, D., 2013. On graduation from fiscal procyclicality. J. Develop. Econ. 100 (1), 32–47.
Furceri, D., Zdzienicka, A., 2012. How costly are debt crises? J. Int. Money Finance 31 (4), 726–742.
Hatchondo, J.C., Martinez, L., 2009. Long-duration bonds and sovereign defaults. J. Int. Econ. 79 (1), 117–125.
Hatchondo, J.C., Martinez, L., Sapriza, H., 2010. Quantitative properties of sovereign default models: solution methods matter. Rev. Econ. Dynam. 13 (4),
919–933.
Hatchondo, J.C., Martinez, L., Roch, F., 2012. Fiscal Rules and the Sovereign Default Premium. The Federal Reserve Bank of Richmond, WP 12-01.
Hatchondo, J.C., Martinez, L., 2012. On the benefits of GDP-indexed government debt: lessons from a model of sovereign defaults. Econ. Quart. 98 (2), 139–
157.
Husain, A.M., Tazhibayeva, K., Ter-Martirosyan, A., 2008. Fiscal Policy and Economic Cycles in Oil-Exporting Countries. IMF WP/08/253.
Ilzetzki, E., Vegh, C.A., 2008. Procyclical Fiscal Policy in Developing Countries: Truth or Fiction? NBER WP 14191.
IMF, 2007. Guide on Resource Revenue Transparency, Fiscal Affairs Department, International Monetary Fund.
IMF, 2015. Global Implications of Lower Oil Prices, IMF Staff Discussion Note, SDN/15/15.
Juvenal, L., Petrella, I., 2015. Speculation in the oil market. J. Appl. Econometr. 30 (4), 621–649.
Kilian, L., Murphy, D.P., 2014. The role of inventories and speculative trading in the global market for crude oil. J. Appl. Econometr. 29 (3), 454–478.
Knittel, C.R., Pindyck, R.S., 2013. The Simple Economics of Commodity Price Speculation. NBER WP 18951.
Kohlscheen, E., O’Connell, S.A., 2015. Trade Credit and Sovereign Debt. WP.
Kumhof, M., Laxton, D., 2013. Simple fiscal policy rules for small open economies. J. Int. Econ. 91 (1), 113–127.
Lizarazo, S.V., 2013. Default risk and risk averse international investors. J. Int. Investors 89 (2), 317–330.
Lopez-Martin, B., 2016. Informal Sector Misallocation. Banco de México Research Document N. 2016-09.
Malone, S.W., 2005. Managing Default Risk for Commodity Dependent Countries. University of Oxford WP #246.
Medina, L., 2010. The Dynamic Effects of Commodity Prices on Fiscal Performance in Latin America. IMF WP/10/192.
Medina, J.P., Soto, C., 2007. Copper Price, Fiscal Policy and Business Cycle in Chile. Central Bank of Chile WP 458.
Mendoza, E.G., 1995. The terms of trade, the real exchange rate, and economic fluctuations. Int. Econ. Rev. 36 (1), 101–137.
Mendoza, E.G., 2010. Sudden stops, financial crises, and leverage. Am. Econ. Rev. 100 (5), 1941–1966.
Mendoza, E.G., Yue, V.Z., 2012. A general equilibrium model of sovereign default and business cycles. Quart. J. Econ. 127 (2), 889–946.
Neumeyer, P.A., Perri, F., 2005. Business cycles in emerging economies, the role of interest rates. J. Monetary Econ. 52 (2), 345–380.
Pallage, S., Robe, M.A., 2003. On the welfare cost of economic fluctuations in developing countries. Int. Econ. Rev. 44 (2), 677–698.
Pieschacon, A., 2012. The value of fiscal discipline for oil-exporting countries. J. Monetary Econ. 59 (3), 250–268.
Roldan-Peña, J., 2012. Default Risk and Economic Activity: A Small Open Economy Model with Sovereign Debt and Default. Banco de México Research
Document N. 2012-16.
Sandleris, G., Sapriza, H., Taddei, F., 2008. Indexed Sovereign Debt: An Applied Framework. WP.
Sandleris, G., Wright, M.L.J., 2013. GDP-Indexed Bonds: A Tool To Reduce Macroeconomic Risk? U. Torcuato Di Tella WP 02/2013.
Schmitt-Grohé, S., Uribe, M., 2007. Optimal simple and implementable monetary and fiscal rules. J. Monetary Econ. 54 (6), 1702–1725.
Schmitt-Grohé, S., Uribe, M., 2015. How Important Are Terms Of Trade Shocks? WP.
Shousha, S., 2016. Macroeconomic Effects of Commodity Booms and Busts: The Role of Financial Frictions. WP.
Snudden, S., 2013. Countercyclical Fiscal Rules for Oil Exporting Countries. IMF WP/13/229.
Spatafora, N., Samake, I., 2012. Commodity Price Shocks and Fiscal Outcomes. IMF WP/12/112.
Tauchen, G., 1986. Finite state Markov-chain approximations to univariate and vector autoregressions. Econ. Lett. 20 (2), 177–181.
Talvi, E., Vegh, C.A., 2005. Tax base variability and procyclical fiscal policy in developing countries. J. Develop. Econ. 78 (1), 156–190.
Tavares, T., 2015. Labor Market Distortions under Sovereign Default Crises. WP.
van der Ploeg, R., 2014. Guidelines for exploiting natural resource wealth. Oxford Rev. Econ. Policy 30 (1), 145–169.
Vegh, C.A., Vuletin, G., 2012. How is tax policy conducted over the business cycle? NBER WP 17753.
Villafuerte, M., Lopez-Murphy, P., 2010. Fiscal Policy in Oil Producing Countries During the Recent Oil Price Cycle. IMF WP/10/28.
Yue, V.Z., 2010. Sovereign default and debt renegotiation. J. Int. Econ. 80 (2), 176–187.

Commodity Price Default

Uploaded by

Copyright:

Available Formats

Commodity Price Default

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Commodity Price Default

Uploaded by

Copyright:

Available Formats

Journal of International Money and Finance 96 (2019) 304–323

Contents lists available at ScienceDirect

Journal of International Money and Finance

Commodity price risk management and fiscal policy in a

2.1. Households and production technology

2.2. The dynamic problem of the government

2.3. International lenders and the price of sovereign bonds

q ¼ E ½M 0  E½1 d  ð1 þ r f Þ1 þ Cov ðM0 ; 1 d Þ ð1 þ rf Þ1

2.4. Definition of equilibrium

Fig. 1. Default decision as a function of assets, productivity and oil price.

Fig. 2. Tax rate as a function of assets, productivity and oil price.

4. Parameters and functional specifications

4.1. Predetermined parameters

Description of parameter Parameter Value

Description of parameter Parameter Value

5. Alternative financial instruments

5.1. Commodity-indexed bonds

5.2. Sale options

Standard deviation Base No oil Indexed Forward Sale

5.3. Forward sales

6.1. Business cycle statistics

Correlation Base No oil Indexed Forward Sale

Average (levels) Base No oil Indexed Forward Sale

6.2. Event analysis: large drops in oil prices

6.3. Partial bond indexation

Fig. 3. Baseline and forward selling models.

Fig. 5. Baseline and option selling models.

Fig. 6. Baseline and indexed bond models.

6.4. Welfare analysis

Fig. 7. Properties of indexed bond model.

6.4.1. Conditional welfare analysis

Thus c is defined as the value that implies this indifference.

6.4.2. Unconditional welfare analysis

6.4.3. Welfare results

Baseline calibration Indexed Forward Sale

Alternative calibration Indexed Forward Sale

Alternative model Indexed Forward Sale

A.1. Model in terms of wealth

A.2. Numerical solution algorithm and computation of moments

A.3. Alternative productivity loss specification during default

Fig. A1. Alternative productivity losses during default.

You might also like

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

q ¼ E ½M 0 E½1 d ð1 þ r f Þ1 þ Cov ðM0 ; 1 d Þ ð1 þ rf Þ1