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Abstract

This paper proposes an insurance scheme to protect a currency from self-fulfilling financial crises. Treating such crises as catastrophes, the recently developed catastrophe insurance bond (CAT bond) can be adapted and applied. The idea is for the insured currency area to issue bonds with an interest payment higher than market alternatives and relieve the area's debt burden (principal and interest) in case of a catastrophic crisis. There are two purposes behind such a design: first, if a crisis occurs, the area being hit can use the forfeited principal as funds to recover; second and more importantly, the bondholders will have an incentive to defend against the speculative attack causing the crisis because they will themselves want to avoid the forfeiture of their debt principal. We study two typical models with self-fulfilling expectations by Obstfeld (1996) and Krugman (1999) and analyze the resulting equilibrium with and without the CAT bond. It is shown that under some conditions, the insurance scheme can indeed help to reduce the threat of a self-fulfilling financial crisis.

Key words: Asian financial crisis; CAT bond; exchange rate

JEL classification: F31; G22

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Since the Asian financial crises of 1997-1998, dozens of papers have discussed issues related to such crises. Three major lines of discussion have arisen: (1) What are the causes of these financial crises? (2) What can the government do when similar incidences happen or are about to happen? (3) What can be or should be done afterwards, either by the government in question or by international organizations such as the IMF. Below we shall briefly review some of the findings in the literature, and then discuss the rationale of this paper.

1.1 Causes of the Asian financial crises

According to Radelet and Sachs (1998), the Asian financial crises can be attributed to three major factors: the international factor, the domestic factor, and intrinsic market failure. After a careful review of the evidence, they find that these crises should not be attributed to deteriorating domestic or international fundamentals of the kind which contributed to crises in other countries in the past. Leaving aside some minor domestic mismanagement in these Asian countries, detrimental though this was, the Asian financial crises are believed to...

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