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But Can't They Hedge??? (Managing Foreign Exchange Risk Under 'Original Sin')

Jul 2003
Working Paper
Slavi Tr. Slavov

This paper analyzes the optimal risk management problem of dollar and yen debtors in East Asian emerging economies afflicted with “original sin.” Given market incompleteness, a soft peg to the dollar makes dollar debtors indifferent between no hedging at all and hedging in the yen-dollar forward market. Furthermore, stabilizing the dollar exchange rate minimizes the costs of market incompleteness to dollar debtors. Given the predominance of dollar debt in these economies, these results provide justification for the soft dollar pegs practiced by most East Asian economies before the 1997 crisis. Finally, a single-currency peg implies zero correlation between the domestic yen and dollar exchange rates. It turns out that this scenario minimizes the costs of market incompleteness for all debtors, relative to a basket peg or a crawl.