Hedging and financial fragility in fixed exchange rate regimes
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Currency crises that coincide with banking crises tend to share at least three elements. First, banks have a currency mismatch between their assets and liabilities. Second, banks do not completely hedge the associated exchange rate risk. Third, there are implicit government guarantees to banks and their foreign creditors. This paper argues that the first two features arise from bank's optimal response to government guarantees. We show that guarantees completely eliminate banks' incentives to hedge the risk of a devaluation. Our model also articulates one reason why governments might be tempted to provide guarantees to bank creditors. Guarantees lower the domestic interest rate and lead to a boom in economic activity. But this boom comes at the cost of a more fragile banking system. In the event of a devaluation, banks renege on foreign debts and declare bankruptcy. © 2001 Elsevier Science B.V. All rights reserved.
Published Version (Please cite this version)10.1016/S0014-2921(01)00090-3
Publication InfoBurnside, A Craig; Eichenbaum, Martin; & Rebelo, Sergio T (2001). Hedging and financial fragility in fixed exchange rate regimes. European Economic Review, 45(7). pp. 1151-1193. 10.1016/S0014-2921(01)00090-3. Retrieved from https://hdl.handle.net/10161/2073.
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Mary Grace Wilson Distinguished Professor
Burnside’s fields of specialization include macroeconomics and international finance. His recent research focuses on foreign exchange markets, empirical methods in finance, and the behavior of prices in housing markets. He has published articles in a number of academic journals, including the American Economic Review, the Journal of Political Economy, the Review of Economic Studies, and the Review of Financial Studies. He is a Research Associate of the National Bure