Coping with Risk through Mismatches : Domestic and International Financial Contracts for Emerging Economies

Abstract

We analyse how short termism, dollarization and foreign jurisdictions are ways of coping with systemic risks prevalent in emerging economies. These are symptoms at least as much as problems. We conclude first that under high systemic risks, the market equilibrium settles in favour of investor protection against price risk (through short-duration peso and dollar contracts) instead of protection against default risk. Second, the option value to litigate in the event of default, which is higher in dollar and foreign-jurisdiction contracts, may explain this equilibrium outcome and, more generally, the ‘original sin’. Third, dollar contracts trump short-duration peso contracts as a risk-coping device; they are a better hedge against inflation volatility and are superior at mitigating the risk of loss given default. Fourth, according to a conservation principle, the mitigation of risk via the use of a coping mechanism allows additional risk taking in other forms, leaving total risk unchanged.