Foreign Reserve Management in an Oil Economy: Macroeconomic Risk as a Real Option

Scandizzo, Pasquale and Pagliacci, Carolina (2010): Foreign Reserve Management in an Oil Economy: Macroeconomic Risk as a Real Option.

Abstract

This paper assesses reserve management for determining optimal or minimal reserves for an oil producing economy under dynamic uncertainty. Reserve benchmarks are formulated taking into consideration the amount of contingent liabilities in foreign exchange that arises during currency crises. These contingent liabilities are derived based on the analogy between holding domestic money and possessing a financial option whose payoff depends on the expected behavior of oil proceeds. When reserve accumulation has an opportunity cost in terms of capital goods, an optimum level of reserves can be established, given the capability of reserves to delay and mitigate currency crises. Alternatively, when reserves constitute the best means to accumulate country wealth, an appropriate minimal reserve level may be calculated. In this case, reserves act as an instrument of self-insurance that guarantees honoring a selected amount of foreign exchange claims at the time of a crisis. Econometric estimates for Venezuela show reasonable numerical values for counterfactual optimal and minimal reserves.

• Item Type: MPRA Paper
• Language: English
• Keywords: uncertainty, optimal reserve, currency crisis, real option
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

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