How global investors might rid themselves of Asian-type crises.

• Author: Miller, Stephen Matteo

Recent debate about reforming the international financial architecture to handle financial crises in emerging markets typically focuses on the relationship between officials. That is, what will finance ministers from developed countries and officials in international financial institutions agree to tell finance ministers in emerging economies? However, in recent times, the motives for this may be ill-conceived as Schwartz (1998: 255) notes, "U.S.-backed bailouts protect investors who lent money to governments or private-sector institutions, not the people who suffer the consequences of unsound policies." Meanwhile, as a currency or sovereign-debt crisis unfolds it may spread to other asset classes and across countries, and the official response may be delayed.

What follows is a summary of proposals that some global investors might eventually rind useful for managing the risk of a country's exposure to a crisis with derivatives, without having to sell-off the country's real and primary financial assets. To do this requires (1) creating an index that quantifies the risk in question, (9.) instituting a derivative security that can be priced, which pays out when the risk is affecting investments, and (3) finding a way to guide trading strategies. The indexes explored are a country's beta, measuring the risk added to global investments from an additional dollar invested in the country, and a country's alpha, measuring how well the country performs relative to average global investments, after adjusting for global systematic risk. Such derivatives may spell the end of the transmission of future Tequila and Asian Crisis risks.

Resolving Emerging Financial Market Crises: A Myriad of Potential Policies or One, More Complete, Market?

Identifying the causes of emerging market financial crises and how such crises can be stopped has been the subject of much debate in recent years. There are presumably many relevant policies to prevent financial crises. Yet, there may be one simple market solution to dampen the effects that financial crises have on our wealth. The economist's task is to figure out how to create a more "complete" market in the sense of making financial risk economically irrelevant. The complete markets methodology is described in the next section and then applied to hedging emerging market investments against financial crises.

Arrow's' World

Kenneth Arrow (1953 in French, 1964 in English) proposes an elegant theory that defines the concept of a world of complete markets, in which shocks have no effect on the economy. In that world, the likelihood of any uncertainty can be quantified and priced, without giving up any resources because, by assumption, contracts are costless to create and enforce. When markets are complete, risk factors may affect our lives but not our livelihoods. Likewise, if risk affects our wealth, then it must be the case that markets are incomplete. The instruments used to complete markets are called state-contingent securities because they pay out a specified amount of money only if a particular state of nature is realized and nothing otherwise. As an example, imagine that we knew that tomorrow there would be an earthquake, a hurricane, or a calm, sunny day. Markets would be complete if we each owned a security that paid us one dollar if there is an earthquake and zero otherwise, a second security that paid us one dollar if there is a hurricane and zero otherwise, and a third that only paid us one dollar for sunshine and zero otherwise. The values of these securities would be tied to the probability of each event's occurrence. Arrow even proved that markets would be complete if we did not have all securities as long as the missing ones could be recreated from the ones we did have. For example, if only the second and third securities existed, the economic impact of the earthquake could still be neutralized if those two securities were combined in such a way that the payoff from the missing earthquake security could be mathematically recreated.

Arrow proposes a world in which earthquakes or hurricanes may happen, but everyone gets one dollar no matter what happens. In fact, Arrow's contribution is too impractical to ever be implemented as he saw it, but it is important because his vision of complete markets identifies the best we can hope to see for the uncertain world in which we live, where resources are scarce. Furthermore, derivatives, such as futures and options, are special state-contingent securities that make completing markets possible and feasible.

Options and the Complete Markets World of Black and Scholes

Derivative markets have existed at least since the 17th century. (1) One recurring problem has always been to value them fairly so they can be sold off in the marketplace. A number of authors have attempted to price stock options. (2) Fischer Black and Myron Scholes (1973), along with Robert Merton (1973), figured out how to price a call option, a financial contract that gives the owner the right to buy shares of a certain company's stock from the party who wrote it, assuming the underlying stock price follows a certain probability law. They did this by assuming an investor can create a risk-free portfolio by buying stock and selling options. Since the holder of the portfolio owns the risk that comes with owning the stock and can sell off that same risk when he sells the call options on the stock, in theory he bears no risk. Thus, Black and Scholes, like Arrow, describe a world in which risk has no economic impact on wealth, so by definition the market for this stock is complete.

If derivative contracts can be priced fairly, they can be an effective means of getting rid of risk. The most predominant form of risk that derivatives have been used to neutralize is price volatility. For instance, wheat farmers can protect themselves against a fall in wheat prices after a bumper-crop year by selling wheat futures contracts to lock in at a certain price. In owning the wheat and selling to someone else the obligation to buy that wheat with a futures contract, the price is effectively fixed. Similarly, investors who believe that the price of a company's stock may fall can buy a put option, a contract that gives the owner the right to sell shares of stock to the put option writer for a certain price. (3) If the price falls below the exercise price specified by the put contract, the writer of the put will lose money in the sense that he is obliged to purchase the shares of stock from the put...