Enhancing reinsurance efficiency using index-based instruments

Purpose – Country alpha swaps are proposed to facilitate emerging market risk-sharing, even during global financial crises. Country alphas measure risk-adjusted performance by subtracting the product of average world index returns and the country's beta, measuring its contribution to global systematic risk, from average country index returns. It has been proposed that emerging market country betas rose during the Asian crisis, and that country beta call options pay out for large increases in risk. Swaps on the difference between country and world index returns have also been proposed. Country alpha swaps combine elements of Merton's and Miller's proposals. Design/methodology/approach – Daily, rolling, synchronous country alphas are estimated from the subset of assets available to all investors in 13 emerging markets between 1995 and 2003, using Scholes and Williams' method. Findings – Country alphas become increasingly negative during the Asian crisis, and typically rise thereafter, eventually becoming positive. Short swap positions compensate investors when alphas are negative, especially during the Asian crisis, while long positions compensate hedging suppliers when alphas are positive. Research limitations – Although inspired by academic research, real world tests will ultimately verify the merits of this idea. Originality/value – Country alpha swaps compensate hedging demanders (suppliers) whenever a country's alpha is negative (positive). Risk sharing might increase and global financial crisis risk in the future might be hedged.