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Author:

• Cyrus CHU
  Academia Sinica

The purpose of this paper is to propose an insurance scheme to protect a country from the hit of self-fulfilling crises. Treating such self-fulfilling crises as catastrophes, the recent innovation of catastrophe insurance can be adopted and applied. The idea of catastrophe insurance is to let the insured area issue bonds with an interest payment higher than the market alternatives, and relieve the area's debt burden (principal and interest) in case a catastrophic crisis with a pre-defined specification hits the area. There are two purposes for such a design: first, the bondholders will have an incentive to defend the speculative attacks to avoid the forfeiture of their debt principal; and second, even if the attack is successful and the crisis occurs, the area being hit can have the forfeited principal as funds to recover. We study two typical models with self-fulfilling expectations by Obsfeld (1996) and Krugman (1999), and analyze the resulting equilibrium with and without the insurance bond. It is shown that under reasonable conditions, the insurance scheme can indeed help relieve the threat of a self-fulfilling financial crisis.