INSURANCE VALUE OF INTERNATIONAL RESERVES An Option Pricing Approach

A quantitative framework is developed to bring forward the insurance motive for holding international reserves. The insurance value of reserves is quantified as the market price of an equivalent option that provides the same insurance coverage as the reserves. This quantitative framework is applied to calculating the cost of a regional insurance arrangement (e.g. an Asian Monetary Fund) and to analyzing one leg of optimal reserve-holding decision. When applied to an illustrative calculation of the cost of a hypothetical regional insurance arrangement, the framework highlights the importance of a mechanism that can expand the asset base of the insurance arrangement. When applied to the optimal reserve-holding decision—using the short-term external debt as the benchmark of comparison—reserve holdings by advanced economies appear to be close to the optimal reserve coverage ratio. In contrast, reserve holdings by emerging markets appear to exceed the optimal reserve coverage ratio by wide margins, offering a quantitative indicator of the limited availability of market-based insurance for emerging markets.