Option Pricing Approach to International Reserves

This paper brings forward the insurance aspect of holding reserves by using the conceptual equivalence between insurance and financial options, and explores when reserves are likely to become the primary means of precautionary arrangement, in particular in emerging markets. The sharp rise in the amount of reserves held by many emerging markets since the mid-1990s can be traced to the rise in the "globalization hazard" that confronts emerging markets. A modest probability of globalization hazard (sudden stop) can induce emerging markets to self-insure fully by hoarding international reserves, rather than relying on nonreserve alternatives of taking precautions. Copyright © 2009 Blackwell Publishing Ltd.