Motivation for the Research
One of the most serious problems that a central bank in an emerging market economy can face is the sudden reversal of capital inflows ("sudden stops" ). Hoarding international reserves can be used to smooth the impact of such reversals, but these reserves are seldom sufficient and always expensive to hold.

In this paper, the authors analyze the investment decisions of a central bank that seeks to minimize the real costs of a sudden stop of capital inflows. Their goal is to provide a simple model to isolate the portfolio problem associated with such an objective.

Research Approach
The paper presents a simple static portfolio model for a central bank concerned with sudden stops. The model is solved under various assumptions on hedging opportunities. Using data from nine countries-Argentina, Brazil, Chile, Indonesia, Korea, Malaysia, Mexico, Thailand, and Turkey-representing emerging market economies open to international capital markets during the 1990s, the authors estimate key parameters of the model from the joint behavior of sudden stops and the S,P implied volatility index (VIX), and then use the parameters to generate optimal portfolios. Finally, they document the impact of different hedging strategies on the availability of reserves during sudden stops.

Key Findings

• In an ideal setting, where countries and investors can identify the jumps in the VIX and there exist call options on these jumps, an average emerging market economy may expect to face a sudden stop with up to 40 percent more reserves than when these options are not included in the central bank's portfolio.
• The main reason behind this important gain is the close relationship between jumps in the VIX and sudden stops: The probability of a sudden stop conditional on a jump in the VIX is about four times the probability of a sudden stop when there is no jump.
• While the probability of a jump in the VIX when there is no sudden stop in emerging markets is slightly above 30 percent, it rises to over 70 percent when a sudden stop takes place in that year.
• Adding richer hedging instruments to the portfolios held by central banks can significantly improve the efficiency of the anti-sudden-stop mechanism.

Implications
Although the VIX is useful because it is correlated with implied volatilities and risks in emerging markets, it also captures problems that are U.S.-specific. Ideally, one would want an index that weights differently U.S. events that are likely to have world-wide systemic effects from those that do not. It should be relatively easy to construct implied volatility indices that isolate the former factors and still preserve the country-exogeneity properties of the VIX. Constructing such indices is important to create benchmarks and develop liquid hedging markets for economies exposed to capital flow volatility, and the authors believe that if hedging practices were to be adopted by central banks generally, we would soon observe the emergence of new implied volatility indices that better match the needs of emerging market economies.

An issue that the authors point to, but do not address in this paper, is the incentive effects that a modified central bank's policy of hedging external shocks may have on the private sector. This is an important concern, as the private sector may undo some of the external insurance in anticipation of the central bank's intervention. To mitigate that potential effect may require coordination of the hedging policy with monetary and regulatory policies. However, even in the absence of such complementary policies, perverse incentive effects are unlikely to be strong enough to fully offset the benefits of more aggressive hedging practices.