Insuring Against Self-Fulfilling Financial Crises

C. Y. Cyrus Chu and Jason J. H. Yeh
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C. Y. Cyrus Chu: Institute of Economics, Academia Sinica, Taiwan
Jason J. H. Yeh: Department of Finance, Chinese University of Hong Kong, Hong Kong

International Journal of Business and Economics, 2005, vol. 4, issue 2, 123-139

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.

Keywords: Asian financial crisis; CAT bond; exchange rate (search for similar items in EconPapers)
JEL-codes: F31 G22 (search for similar items in EconPapers)
Date: 2005
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