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**_Policy, Planning, and Research Working Paper Series_**

## **135. PPR Working Papers Catalog of Numbers 1 to 200**

## **136. Pricing Commodity Bonds** Using Binomial **Option** Pricing

## Raghuram Rajan

_Binomial option pricing offers an easy, flexible, comprehensive method for pricingcommodity-linkedbondswhenthereis risk both of default and of changes in commodity prices._ Commodity-linked bonds have received considerable attention recently as a way to tailor a developing country's debt repayments to its ability to pay. A commodity bond makes repayments subject to fluctuations in the price of the underlying commodity.

Previously, formulas for pricing these bonds were based on the standard continuous-time option-pricing method. Solution of the derived differential equation was difficult even when assumptions were simplified.

Binomial option pricing offers a simpler, moreintuitive, and more flexible formula for pricing commodity-linked bonds when there is risk both of default and of changes in commodity prices.

Binomial probability distribution trees are used to develop the pricing formula. Extensions to the model - including the pricing of secondary market debt - are easily incorporated. The technique can also be used to derive, among other things, the implied performance risk of secondary market debt.

This paper is a product of the International Commodity Markets Division, International Economics Department. Please contact Julie Raulin, room S7-069, extension 33715.

# **137. Trends** In **Nontariff** Barriers **of Developed Countries: 1966-1986**

## Sam Laird and Alexander Yeats

_The near doubling ofnontariffbarriers in the developed countries has limited the developing countries' ability to increase exports -particularly in agriculture and such labor-intensive products as textiles, - clothing, and footwear and deal effectively with their debt burdens._ In the major developed countries, 25 percent of imports were affected by nontariff barriers in 1966. Twenty years later that number had nearly doubled, to 48 percent.

Some nontariff barriers affecting fuels were liberalized, but new trade restrictions were introduced on imports of agricultural products, textiles, clothing, ferrous metals, and nonelectric machinery. Nontariff barriers grew faster in the European Community than in the United States or Japan.

Existing GATT arrangements have lowered tariffs but have not stemmed the growth of nontariff protection. Procedures for liberalizing nontariff barriers must be established in multilateral trade negotiations like the Uruguay Round.

These barriers limit the developing countries' ability to expand their export - opportunities particularly in agriculture and such labor-intensive products as textiles, clothing, and footwear. As a result, they are unable to achieve economic growth and deal effectively with their debt burden.

This paper is a product of the International Trade Division, International Economics Department. Please contact Jean Epps, room S8-037, extension 33710.

## **138.** Fiscal **Adjustment and Deficit** Financing during **the Debt Crisis**

## William R. Easterly

_Highly indebted countries are probably better off raising conventional taxes and cutting current spending - rather than raising taxes on financial intermediation and cutting public investment. But shifting policies may require the breathing space only new external financing or debt relief would provide._ To study the adjustment to the debt crisis, the author compared the experience of seven 'crisis" debtor countries (Argentina, Brazil, Chile, Mexico, Morocco, Yugoslavia, and the Philippines) with those of five 'noncrisis" debtor countries (Colombia, Indonesia, Korea, Turkey, and Thailand).

In response to a sharp reduction in external capital flows, the crisis countries rescheduled their debt during 1982-87. The noncrisis group avoided debt rescheduling during that period and maintained access to external capital.

Most of the noncrisis countries followed an approach of modest domestic financing at market interest rates. This was less costly for private investment because financial savings grew rapidly.

In the crisis countries, public investment was the locus of fiscal adjustment. Most of the crisis countries took the approach of increased domestic financing through taxes on financial intermediation - through reserve requirements, high inflation, and interest rate controls. In the short run, this tax precipitated capital flight and financial disintermediation.

The crisis countries would probably have been better off raising conventional taxes and cutting current spending rather than raising taxes on financial intermediation and cutting public investment.

Small increases in rates or coverage of broad-based taxes (such as income or consumption) are probably less distortionary for the same amount of additional revenue than taxes on financial intermediation. Conventional broad-based taxes penalize mainly consumption. The tax on financial intermediation falls more on investment and may cause more severe damage in the long run.

In a situation that calledforquick action, the behavior of the crisis countries was understandable. It takes more time to raise conventional taxes than to tax financial balances, and it takes more time (because it is harder) to cut current spending than to cut public investment.

Shifting to sounder policies in the crisis countries may require the breathing space only new external financing or relief from debt service would provide.

This paper is a product of the Macroeconomic Adjustment and Growth Division, Country Economics Department. Please contact Raquel Luz, room Nil057, extension 61760.

## **139. A Conceptual Framework for Adjustment Policies**

## Bela Balassa

_The principal objective of stabilization policies under the auspices of the International Monetary Fund is to improve the balance of payments. In turn, increasing the rate ofgrowth ofoutput may be considered the principal objective ofadjustment policies under World Bank auspices._ The principal objective of stabilization policies under the auspices of the Interna-