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Chang Ma and Mr. Fabian Valencia

and those from income smoothing. The first channel emerges from the change in default incentives induced by the reduction in downside risks to income through put options. The second channel is similar to Lucas (1987) , in which lower income fluctuations translate into a smoother consumption path, which increases welfare for risk averse agents. We conclude that about 90 percent of the welfare gains stem from the borrowing costs channel. Compared to the economy without hedging, risk spreads on debt are 19 basis points lower in the hedging economy. 3 We also find

Chang Ma and Mr. Fabian Valencia
Over the past two decades, Mexico has hedged oil price risk through the purchase of put options. We examine the resulting welfare gains using a standard sovereign default model calibrated to Mexican data. We show that hedging increases welfare by reducing income volatility and reducing risk spreads on sovereign debt. We find welfare gains equivalent to a permanent increase in consumption of 0.44 percent with 90 percent of these gains stemming from lower risk spreads.
Chang Ma and Mr. Fabian Valencia

A Proof of Proposition 1 B Proof of Proposition 2 C Proof of Proposition 3 D Proof of Proposition 4 III Algorithm IV Estimation of Oil Price Process V Option Pricing Tables 1 Actual Strike Prices from Options 2 Parameters 3 Stochastic Steady State in the Hedging and No-hedging Economies 4 Sensitivity Analysis 5 Welfare Gains from Selling Oil Forward 6 Risk Averse Investors: Hedging and No-hedging Economies Figures 1 Oil Production, Oil Prices, and Sovereign Spreads 2 Mexico’s Oil Hedging Program 3 Two-period Model 4 Welfare

International Monetary Fund. Asia and Pacific Dept

t e r e s t P a y 2013 F X d e b t s h a r e 2013 F X s h o c k X D e b t X = D e b t 2013 + D e b t 2013 F X d e b t s h o c k 2013 + F X s h o c k X Assumptions for each scenario are presented in Table 1 . Table 1. Summary of Scenarios Considered in Stress Tests Natural Hedge