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Professor Salih Neftci is at the City University of New York. We thank Eduardo Borensztein, Jorge Chan-Lau, Stijn Claessens, Udaibir S. Das, Randall Dodd, Dhaneshwar Ghura, Francois Haas, Joannes Mongardini, Andre Santos, and Amadou Sy for their comments and suggestions. All errors and omissions remain our sole responsibility.
It is noted that default is an option that a country may resort to under certain conditions. In this paper, we assume that costs of default are too huge for the country to cash the option of default.
For descriptions about commodity-liked bonds, see O’Hara (1984), Atta-Mensah (2004), and Privolos and Duncan (1991). For description and benefits of GDP-linked bonds, see Borensztein and Mauro (2004).
There are equal reasons to hedging imports as they are disruptive too.
According to British Bankers’ Association estimates, starting from 2005, the notional global amount of credit derivatives has been larger than the global amount of debt outstanding.
For example, Kazakhstan has a CDS market even though it does not have outstanding sovereign bonds.
These are options with strike price equaling the spot price.
The convenience yield is an imputed yield on the underlying instrument because warehousing commodities is apparently a convenient facility for the commodity user.
The underlying price is the futures price instead of spot price. Traders write options on futures because the commodity futures market is more liquid then the spot market.
A 20 percent out-of-the-money put will start providing insurance after the commodity prices fall more than 20 percent.
Volatility smile refers to a pattern in which an ATM option tends to have lower implied volatility than OTM or ITM options.
Greeks is a term that summarizes the sensitivity of the option price with respect to changes in various parameters and variables. The smoother Greeks are, the easier it is to hedge the option.
Gamma is the second derivative of the option price formula with respect to the underlying risk. It represents the curvature of the option. Delta is the first derivative of the option price with respect to the underlying risk.
A digital put option is an option in which the payoff is fixed after the price of the underlying instrument moves below the strike price.