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.
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