Abstract
Given the substantial instability in all primary commodity markets, one would expect countries that depend on a single primary export for most of their foreign earnings to experience especially sharp fluctuations in export earnings and their underlying wealth. To the extent that these fluctuations affect consumption, they are costly, and we would expect such countries to seek ways of managing these fluctuations and reducing their costs. In many countries the nature of the resource endowment and its comparative advantage rule out production diversification as a significant near-term strategy, and we assume it away here. In addition, we rule out diversification via exchange of equity investments with foreigners. In this paper we consider the cost of export risk and show the potential contribution of commodity bonds in this context. We show that, in theory, appropriate commodity bonds can, in fact, achieve optimal smoothing of i.i.d. export price disturbances-if that is what countries really want or need. Commodity bonds (c-bonds) are bonds whose principal repayment (and perhaps dividend payments) may be made in units of physical commodity (or the terminal value of some appropriate futures contract). Typically, the bond buyer has the option to receive the nominal face value or the commodity bundle. In the finance literature, studies of the pricing of c-bonds (Schwartz, Carr, Priovolos) do not distinguish bonds issued by foreign governments from private corporate bond issues. However, the literature on foreign borrowing recognizes that the distinction is crucial. Sovereign Borrowing and Default Prevention
Published Version
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