Superficially, commodity-indexed bonds resemble a combination of a debt and a contract in futures. They are particularly useful in a country dependent on a single commodity for which prices are volatile. These financial instruments involve a tradeoff between gains in risk-sharing and a deterioration in incentives. The precise costs and benefits of commodity-contingent contracts in international lending depend on the model employed. Commodity indexing seems to work best when : (i) the borrower is heavily concentrated in a commodity for which prices are so volatile that income fluctuates greatly; (ii) information is fully available about how borrowed funds are used and thus whether conditionality is meaningful; the borrower has no control over the index used in the contingent contract; and (iv) there is a low"beta"between returns on the commodity and returns from the rest of the lenders portfolio. Many of the arguments made for a commodity-dependent borrower may also be made for countries subject to other risks, for example, a country that has borrowed largely in dollars and is thereby exposed to high currency risks.
