- 13 Nov 2006
- Working Paper Summaries
A New Framework for Analyzing and Managing Macrofinancial Risks of An Economy
Executive Summary — The vulnerability of a national economy to volatility in the global markets for credit, currencies, commodities, and other assets has become a central concern of policymakers, credit analysts, and investors everywhere. This paper describes a new framework for analyzing a country's exposure to macroeconomic risks based on the theory and practice of contingent claims analysis. (A contingent claim is any financial asset for which future payoff depends on the value of another asset.) In this framework, the sectors of a national economy are viewed as interconnected portfolios of assets, liabilities, and guarantees that can be analyzed like puts and calls. The framework makes it transparent how risks are transferred across sectors, and how they can accumulate in the balance sheet of the public sector and ultimately lead to a default by the government. Key concepts include:
- The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of countries' economic and financial systems.
- Contingent claims analysis provides a natural framework for analysis of mismatches between an entity's assets and liabilities, such as currency and maturity mismatches on balance sheets.
- Policies or actions that reduce these mismatches will help reduce risk and vulnerability.
- This framework is useful to both the public and private sectors.
The high cost of international economic and financial crises highlights the need for a comprehensive framework to assess the robustness of national economic and financial systems. This paper proposes a new comprehensive approach to measure, analyze, and manage macroeconomic risk based on the theory and practice of modern contingent claims analysis (CCA). We illustrate how to use the CCA approach to model and measure sectoral and national risk exposures, and analyze policies to offset their potentially harmful effects. This new framework provides economic balance sheets for inter-linked sectors and a risk accounting framework for an economy. CCA provides a natural framework for analysis of mismatches between an entity's assets and liabilities, such as currency and maturity mismatches on balance sheets. Policies or actions that reduce these mismatches will help reduce risk and vulnerability. It also provides a new framework for sovereign capital structure analysis. It is useful for assessing vulnerability, policy analysis, risk management, investment analysis, and design of risk control strategies. Both public and private sector participants can benefit from pursuing ways to facilitate more efficient macro risk accounting, improve price and volatility discovery, and expand international risk intermediation activities.