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.
creditor would lend to consumers who would default with probability 1. In the following propositions, we analyze the implications for welfare under all these cases except for the last one.
Proposition 2. No Default in Equilibrium
When default is too costly, such that the economy does not default in equilibrium, introducing hedgingincreasessocialwelfare and the country borrows more .
Proof . See Appendix B . Q.E.D .
In this case, hedging is clearly beneficial. Income becomes smoother and the economy can afford to borrow more. This insight is similar to