Introduction Emerging markets have been exposed to remarkable market risks and it is by now folk wisdom that, if given a choice, they should be endowed with instruments of hedging against downside risks (see Caballero, 2003; Caballero and Panageas, 2003; Shiller, 2003).

Finding out which factors are the fundamental source of volatility for each country — for example, the prices of oil for Mexico, of coffee for Brazil, of semiconductors for Korea, of copper for Chile, and so on — is recognized as a crucial step in order to construct the appropriate hedging instruments, which will be contingent on observable variables (Caballero, 2003). Yet, it remains to be answered the question concerning the proper application of derivative securities that can be used to construct hedging strategies and the optimal hedging policy.

The purpose of this chapter is to examine the hedging decisions of an economy which is exposed to market risks and is subject to collateral constraints. The model considered here is a sovereign debt one, with default risk and endogenous collateral.

Collateral is typically used to secure loans. Since the article by Kiyotaki and Moore (1997), it has been pointed out that if collateral is endogenous, then the debt capacity of firms is altered, causing fluctuations in output (Krishnamurthy, 2003). In this chapter, a model is discussed where the use of 1 2 E. Agliardi & R. Andergassen hedging instruments may affect collateral values and thus, the debt capacity of the debtor. In most literature relating to the 1980s debt crisis and following the Bulow and Rogoff models (1989, 1991), a given proportion of output or exports are assumed to be available for repayment of outstanding debt. This means that repayment is modeled as an output tax and actual repayment is the minimum of this amount and debt.