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November/December 1991
Volume 76, Number 6

Federal Reserve
Bank of Atlanta
In This Issue:
A Liberal Discussion of
Financial Liberalization
Evaluating Embedded Options
Prospects for
Energy Supplies
Review Essay






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JSpnpmìc
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November/December 1991, Volume 76, Number 6

J^MMW
of Atlanta
President

Robert P. Forrestal

Senior Vice President and
Director of Research
Sheila L. Tschinkel

Vice President and
Associate Director of Research
B. Frank King

Research Department

William Curt Hunter, Vice President, Basic Research
Mary Susan Rosenbaum, Vice President, Macropolicy
William Roberds, Research Officer, Macropolicy
Larry D. Wall, Research Officer, Financial

Public Affairs

Bobbie H. McCrackin, Vice President
Joycelyn T. Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation

The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
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information. ISSN 0732-1813



(Contents

November/December 1991, Volume 76. Number 6

\

A Liberal Discussion of
Financial Liberalization

Financial liberalization often seems to have some immediate
negative consequences. Why, then, would a country want financial
liberalization? This article examines that question, specifically in
light of Taiwan's recent experience as a newly industrialized country opening its economy to international flows of capital.
In his discussion of the consequences of financial liberalization,
the author distinguishes between measures of economic performance
and economic welfare and considers some of the economic issues involved in both internal and external liberalization. The close examination of Taiwan's experience leads to the conclusion that, although
liberalization may not immediately serve to increase economic
growth, by expanding choice sets and more efficiently allocating resources liberalization is likely to increase economic welfare.

.Evaluating
Embedded Options

Many banks, financial institutions, and investors are buying complicated financial instruments in attempts to control interest rate exposure. Options embedded in these instruments often make them
difficult to understand and to value. This article discusses a procedure that in some instances eases valuing embedded options.
The technique involves separating the option from the financial
contract in which it is embedded. Two examples—valuing the call
option sometimes embedded in Treasury bonds and valuing the
"wild card" option embedded in Treasury bond futures contracts—
demonstrate ways to determine whether the separation technique
can be correctly applied.

Thomas J. Cunningham

9

Hugh Cohen

Y1

FYI-—-Prospects

Energy Supplies
Gene D. Sullivan

.Review Essay

Janice L. Boucher

/ndex for 1991



for

Energy costs and availability are concerns around the world.
Higher oil prices that are expected to persist would likely cause a
turn to additional sources of oil and a broad array of alternative energy sources. This article presents an inventory of these sources,
supplying information on production costs when available.
Europe 1992: An American

Perspective

Edited by Gary Clyde Hufbauer




i û Liberal
Discussion of
Financial
Liberalization
Thomas J. Cunningham

n 1986 Taiwan enjoyed a real, or inflation-adjusted, growth rate of
about twelve and a half percent, a trade surplus that exceeded U.S. $15
billion, an unemployment rate of two and two-thirds percent (and
falling), a personal savings rate of about one-third, with additional capital from overseas desiring entry but legally restricted, and prices, as
measured on the wholesale level, that were falling at about three and a half
percent per year. In 1987 the country briefly undertook a dramatic set of
financial liberalization measures, substantially opening the economy to international flows of capital. Consistent with standard open-economy macroeconomic theory, growth slowed, inflation became less negative, and the
current account deteriorated. By standards of other industrial nations, Taiwan was, and still is, performing quite nicely. Nevertheless, in view of the
immediate consequences, the question should be asked: Why would a country want financial liberalization?
The point of this article is to examine that question. The next section begins with a brief discussion making the important distinction between measures of economic performance (as generally thought of in the United
States) and the more important but less familiar measures of economic welfare. Although analysts typically talk about economic growth in terms of the
former, they usually mean to talk about it in terms of the latter. The third
section of the article formally discusses the process of both internal and external liberalization and comments on some of the economic issues involved. The article then applies the concepts of the previous two sections to
the process of economic liberalization as it has occurred in Taiwan, one of
the premier newly industrialized economies that has recently undergone
substantial liberalization. The concluding section provides a summary.
1

The author is a senior
economist in the macropolicy
section of the Atlanta Fed's
Research Department. He
thanks Ramon Moreno for
helpful comments.

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Econom ic Review 7

A Digression on Measures of Economic
Performance and Economic Welfare
Even though growth in Taiwan has slowed, that
fact does not necessarily mean that the economy, on
net, is not as well off as it otherwise might have
b e e n . E c o n o m i c growth is usually treated as the
b e n c h m a r k against which j u d g m e n t s of economic
welfare are made, but it is not always the appropriate
metric.
The distinction between growth and welfare is
best illustrated by discussing the difference between
growth as simply measured by the percentage change
in real gross national product (GNP) during some period and growth in per capita G N P over that same
time. G r o w t h per se is largely unavoidable in an
economy with a growing population. A larger population creates a larger labor pool, which in turn is capable of producing more goods and services as well
as creating a demand for additional output. These
forces account for simple real growth. Of more importance, however, is whether aggregate G N P growth
is outpacing the growth in population, in which case
per capita G N P is rising and everyone in the economy could, potentially, be better off. If simple econ o m i c g r o w t h is lagging p o p u l a t i o n g r o w t h , the
economy is generally thought of as becoming poorer
(though possibly quite large). So long as economic
growth—that is, income—lags population growth,
people will continue to feel poorer because, on average, they are.
In addition to the issue of growth versus per capita
growth there is the matter of income distribution.
While per capita real income growth is a necessary
condition for everyone in the economy to benefit, it is
clearly not sufficient. The fact that per capita income
is growing says nothing about the ultimate distribution
of individual incomes. If the distribution of income is
considered part of the measure of overall economic
welfare, a rapidly growing economy with a sufficiently unequal distribution of income could conceivably
be characterized by declining social welfare, even as
average per capita income grows. Although not the focus of this article, it should be noted that during the
period of Taiwan's substantial industrialization, income inequality measures showed a pronounced drop.
For example, from 1960 to 1980, the ratio of the income share of the highest quintile to the lowest was
more than cut in half, from 8.9 to 4.2.
The importance of these welfare criteria will become apparent as they are applied to the discussion of
Eco no m ic
2



2

Review

liberalization in Taiwan in a later section. Before that,
however, an overview of the literature regarding liberalization is in order.

L liberalization
Financial development and financial liberalization
often go hand in hand. The purpose of this section is
to set out the notion of financial liberalization as it
c o m m o n l y applies to developing nations. It is not
necessary, however, to confine such a discussion to
economies in the process of industrialization. Nations
with developed financial and industrial markets can be
studied within this framework as well because the financial development process is ongoing. The United
States, in fact, is continuously developing and is quite
far from the "full and complete" set of financial markets of which economists frequently speak.
Nevertheless, the importance of the idea of financial liberalization is usually seen in the context of developing nations, where some industrial and general
economic development has taken place but secondary
debt and equity markets have not yet emerged and
where international capital movements may be regulated. This discussion of financial liberalization divides the process into its domestic and international
components.
Domestic Financial Liberalization, or Easing Financial Repression. Financial intermediation is the
process of matching up savings held by people or
firms with people or Firms that wish to borrow. Banks
are an obvious example of financial intermediaries and
are found fairly universally. However, their ability to
allocate savings among alternative uses is frequently
hampered by regulation. Interest rate ceilings on loans
and deposit accounts, for example, are common restrictions. In the face of limitations on rates of return
(interest rate ceilings on their loans) banks will choose
relatively safe loans and forgo riskier but potentially
more profitable and developmentally useful projects.
In this simple case, liberalization can aid development
by allowing lenders seeking a higher rate of return and
borrowers having projects with a higher rate of return
to come to mutually beneficial (and possibly socially
beneficial) terms.
Ronald I. McKinnon (1973) and Edward S. Shaw
(1973) m a k e precisely this argument. The crux of
M c K i n n o n - S h a w , as the h y p o t h e s i s has b e c o m e
known, is that regulation of the banking system (particularly interest rates) should be liberalized in developNovember/December 1991

ing nations to speed the development process. Because
banks are frequently the sole purveyors of financial intermediation, eliminating the economic distortions
brought about by financial regulations would promote
a more efficient allocation of capital within the economy, which, in turn, would promote economic developm e n t and g r o w t h . S t a t e d d i f f e r e n t l y , f i n a n c i a l
"repression," to use McKinnon's term, may specifically hamper the banking sector, stilling economic development by misallocating capital resources. Easing the
financial repression—liberalization—thus would result
in a more efficient allocation of capital and a higher
rate of economic growth.
In later work discussing empirical support for his
earlier hypothesis, McKinnon (1989) examines several
Pacific Basin economies in search of evidence that an
easing of financial repression coincides with relatively
high (or higher) real rates of economic growth. He
finds that high—sometimes astonishingly high—interest rates, both real and nominal, are associated with an
easing of financial repression. These rates reflect a
high demand for capital, in turn indicating the high
productivity of additional investment. Thus he finds a
seemingly puzzling result that supports the McKinnonShaw paradigm: high interest rates are associated with
high growth rates.
At first glance paradoxical, the finding is not really
surprising. If the real return on investment is high, the
implication is that the growth resulting from a given
quantity of investment will also be relatively high. At
the same time, a high real rate of interest encourages
savings. The net result is that when interest rates are
high as a result of market forces alone, relatively high
growth can be expected. Moreover, the higher income
growth may promote even greater savings, implying a
higher future growth rate, too.
Critics of McKinnon-Shaw (called "neostructuralists") argue that the easing of financial repression may
not lead to higher growth rates, though it certainly will
attract funds to the banking industry. The neostructuralists argue that informal, loosely organized intermediation will occur in economies whose primary
financial intermediary is a repressed banking sector.
An easing of interest rate ceilings would allow banks
to compete more aggressively for capital, thereby
shifting it from the informal markets to banks. However, that adjustment would not necessarily lead to more
growth because banks are faced with reserve requirements that would tie up a significant quantity of the
newly attracted funds. The neostructuralists contend
that for McKinnon-Shaw to work, higher interest rates
must not only attract funds to the banking sector but,

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on net, increase the total pool of savings (in both the
b a n k i n g and i n f o r m a l i n t e r m e d i a r i e s sectors) by
enough to offset the loss to required reserves imposed
on the banking system. Their conclusion is that developing economies might as well leave interest rate ceilings in place and not interfere with the informal
intermediation process (see Paul Burkett 1987).
Yoon Je Cho (1990) has pointed out that the disagreement between M c K i n n o n - S h a w and the neostructuralists is not about the value of financial liberalization per se but the way to go about achieving it.
Both parties, Cho claims, want to expand the intermediation process. The question is whether the informal sector or the formal banking sector is more
efficient. Unfortunately, relatively little hard and
systematic information is available about informal
markets because they are, in fact, informal. It seems
important to acknowledge, however, that even informal intermediaries, if they are pooling savings, must
hold some reserves against "withdrawals." Moreover,
because the formal banking system often has access to
sources of temporary funding and insurance not available informally, the banking sector may actually be
able to get by with a lower overall ratio of reserves to
deposits. Further, as the absolute size of the banking
sector expands, a simple appeal to the law of large
numbers provides some predictability of the demand
for withdrawals—that is, as the number of depositors
increase, deposit flows will become increasingly predictable (see Valerie R. Bencivenga and Bruce Smith
1991).
In addition to the debate about increasing the overall amount of intermediation activity, another issue is
the desirability of relatively high interest rates in the
allocation of capital. The McKinnon-Shaw proposition holds that a higher formal rate of interest is likely
to draw capital away from relatively inefficient selffinanced or informally financed projects toward projects having a high rate of real return. Cho argues that
as an economy liberalizes domestically the set of investment opportunities available to the banking sector
should be larger than the set available to the informally organized market. Although this question is, in a
strict sense, an empirical one that cannot be pursued
because of lack of data about informal markets, Cho
argues that only under extreme circumstances would
informal markets be able to match the allocative performance of an unfettered banking system. In addition,
informal markets are likely to find themselves constrained by a smaller information set, further enhancing the banking sector's relative advantage in terms of
efficiency.
Economic Review

3

The process of developing financial intermediation—called "financial d e e p e n i n g " — g o e s beyond
simply unrepressing, or liberalizing, the banking sector. Financial deepening involves developing active
stock and bond markets as well. Nevertheless, because
the development of secondary debt and equity markets
usually comes relatively late in the overall economic
development process, empirical measures of financial
deepening typically focus exclusively on development
of the banking sector.
The standard measure of financial deepening used
for developing economies is the ratio of M2 to GNP.
Although M2 is generally thought of simply as a measure of "money," in fact it actually measures the sum
of currency plus various forms of deposits in banks. If
the banking sector is not functioning as an attractive or
useful financial intermediary, the economy will, in aggregate, minimize its holdings of wealth in banks. As
a consequence the M2/GNP number will be low, signaling the banking system's shortcomings as a financial intermediary. According to McKinnon-Shaw, if
financial repressions were lifted and the banking sector allowed to function effectively, the result would be
growth in banks' balance sheets and thus a rising ratio
of M2 to income (GNP).
McKinnon (1989) argues that this process is indeed
observed in economies that have experienced relatively rapid growth in the last few decades. For example,
from 1960 to 1980 the M2-to-GNP ratio has moved
from 0.29 to 0.91 in Germany, from 0.11 to 0.34 in
Korea, and from 0.17 to 0.75 in Taiwan. In contrast,
for the same period the ratio fell from 0.24 to 0.23 in
Argentina and rose only incrementally from 0.15 to
0.16 and from 0.19 to 0.22 for Brazil and Colombia,
respectively.
Moreover, McKinnon shows that measures of financial asset growth for the banking sector were positively related to relatively high real growth rates and
positive real interest rales for the period from 1971 to
1980. He provides an interesting comparison of countries grouped into three categories (using International
Monetary Fund classifications): countries with positive real interest rates, moderately negative real interest rates, and severely negative real interest rates.
Countries with high real interest rates had high, frequently double-digit, financial asset growth and high
single-digit real growth. Furthermore, he found that
countries with severely negative real rates had low and
often negative rates of financial growth and real
growth rates.
Bencivenga and Smith (1991) have presented a formal model broadly consistent with the McKinnon-

4




Eco no m ic Review

Shaw story. Their model is quite general, featuring
savings that can be held in liquid forms (consumption
goods) or illiquid forms (like "fixed" capital) as well as
financial intermediaries that face reserve-requirement
restrictions. They show that under relatively reasonable circumstances (in which savers are adequately
risk averse) an economy with formal financial intermediaries is likely to invest more of its savings in capital (the illiquid asset) than an economy relying on
self-financing (that is, informal financing) and thus to
enjoy a higher rate of real growth. In Bencivenga and
Smith's model a higher rate of real growth occurs even
though the presence of intermediaries in the economy
may not necessarily increase the overall rate of saving.
Opening the Economy to International Capital
Movements. Eliminating domestic financial repression is an important component of financial liberalization, and the policy issues surrounding d o m e s t i c
liberalization are relatively clear-cut: imposing distortions on domestic financial intermediation hinders
growth. Although there may be some legitimate and
important debate about the appropriate means of managing, with minimal cost, the transition to a financially
deep economy, the concerns are about means and not
ends. The desirability of effective intermediation and
its contributions to growth are not in question.
A much less settled issue involves the liberalization of international capital movements. Economies
frequently impose a series of restrictions on capital
movements across borders that may take the form of
exchange rate controls and currency restrictions or
capital restrictions limiting investment abilities (frequently in both directions across borders). Exchange
rate controls usually manifest themselves in a fixed
exchange rate, perhaps with restrictions on which institutions may engage in foreign exchange transactions. Currency restrictions generally prohibit the use of
currencies other than that issued by the domestic monetary authority. Of restrictions limiting cross-border investments, those that prohibit domestic residents from
investing abroad are usually motivated by a desire to
stop capital flight, while those forbidding foreign
ownership of domestic assets tend to grow out of
sovereignty-related fears or concerns about the repatriation of profits to external owners of capital. Capital inflows today represent an outflowing stream of
debt or equity claims that will mean debt service or
profit repatriation to be paid abroad in the future, and
this flow may potentially account for a large portion
of domestic output.
The two forms of restrictions are not independent,
for balance of payments mechanics connect trade and
November/December 1991

capital flows with exchange rate movements. Consider
an economy with a fixed exchange rate that has a surplus in the balance of trade. There are two ways this
surplus can be accommodated. Either the economy
takes an offsetting quantity of foreign financial instruments (that is, the balance of trade surplus is matched
by a capital account deficit; the country is a net lender)
or the monetary authority intervenes, selling enough
of its assets to keep the exchange rate constant. This
latter strategy can become problematic when the monetary authority runs out of assets, as in the example
presented later.
In an economy such as that described above, the acquisition of foreign assets by domestic residents seems
to pose no problem. If, however, instead of a trade surplus an economy is experiencing a balance-of-trade
deficit, foreign agents are likely to acquire domestic assets. This development may not be particularly popular.
Without the economy's central bank specifically intervening (subordinating its domestic economic concerns)
in the adjustment process, the two accounts must balance after exchange rate changes. In imposing exchange restrictions, the ability of an economy to run a
balance-of-trade deficit is thus financially constrained.
External financial liberalization removes barriers
to international capital flows, but the free flow of cap-^
ital internationally may or may not improve economic
performance and welfare. Effects on economic performance are fairly easy to evaluate. Aggregate production is, in a general sense, a function of labor, capital,
technology, and natural resources. Economic growth
requires that at least one of these components change.
Financial liberalization affects economic performance
through its impact on the growth rate of the capital
stock. There are two possibilities. If the economy offers attractive investment opportunities but simply
cannot internally generate enough savings for growth,
then capital will, on net, flow into the economy as liberalization occurs. The economy will grow faster, and
(ignoring issues of the repatriation of profits and debt
service and a political fear of foreign ownership of domestic assets) welfare can improve.
The more common result of liberalization, however, is a net outflow of capital. Domestically generated
savings go abroad, where risk-adjusted real rates of return are higher. Especially in a relatively undeveloped
economy, watching domestic savings leave the country can be politically and economically painful. Indeed, the reason such controls were established in the
first place often is to force domestic investment of domestically accumulated capital—to attempt to limit
"capital flight." These controls usually enjoy only
3


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limited success. Nonetheless, to the extent that they do
contain capital movement, the net result of removing
the controls may be a decrease in the capital growth
rate at home as capital is free to flow out in search of a
higher rate of return. In this case the liberalization process may lead to a lower rate of real growth.
While having capital controls in place enhances domestic capital growth to some degree, simply raising the
possibility of establishing capital controls can be detrimental. Controls are frequently imposed in something of
a crisis environment—when relatively large portions of
domestic capital seem to be moving abroad—and the

External financial liberalization removes
barriers to international capital flows, but
the free flow of capital internationally may
or may not improve economic performance
and welfare.
threat of controls may only serve to make the crisis
worse. In the face of potential capital flight restriction,
the most reasonable thing for holders of capital to do
is to move it abroad before restrictions are imposed.
This reaction only compounds the problem. The threat
of controls also may discourage foreign capital from
flowing into the country as investors fear they may not
be able to recapture all the fruits of their investment.
Consequently, anticipated capital restrictions may induce a capital outflow prior to the imposition of the restrictions, the magnitude of which may be greater than
what would have happened in their absence.
The welfare issue surrounding financial liberalization is generally less clear. It is simple only in the case
of capital inflow that creates a rise in domestic incomes and that is not complicated by repatriation of
profits. (Scenarios can be devised wherein profit repatriation keeps domestic incomes from rising, but in
principle the issue is clear-cut.) In contrast, the prohibition of capital flight has complex effects on welfare
that are difficult to measure. The reason domestic residents wish to hold their savings abroad is that they
expect to earn a higher return abroad, raising their
Economic Review

5

income. Thus, while capital flight may slow domestic
economic growth, its effect on income may be ambiguous. Specifically, domestic residents investing
abroad will have higher incomes than they would have
if capital controls were imposed, whereas those who
do not have additional capital with which to work will
have lower relative incomes. The usual test applied
here is to gauge whether there is, in principle, some
means by which the winners could compensate the
losers so that the winners still come out ahead while
the losers would be indifferent to whether or not there
are restrictions on investing abroad. Under these conditions, this surrogate measure of overall welfare indicates improvement.
Considering these issues establishes a framework
for thinking about the overall problems of financial
liberalization. T h e f o l l o w i n g d i s c u s s i o n f o c u s e s
specifically on financial liberalization in Taiwan and
its economic effects.
4

7Tie

Recent Experience of Taiwan

Mercantilism Run A m o k . Before Adam Smith
published The Wealth of Nations (in 1776) the predominant way of thinking about measuring a nation's
wealth was in terms of its stock of gold. Mercantilists,
as they are called, believed that the way to increase a
nation's wealth was to increase its gold stock by running a trade surplus and letting the resulting inflow of
gold simply pile up. Smith argued that a more appropriate measure of a nation's wealth was its sustainable
flow of income, so the mercantilist prescription for
lopsided trade was not really appropriate. David Hume
later, and for the purposes of this discussion quite importantly, argued that the mercantilist prescription itself was unsustainable because a gold inflow would
tend to result in inflation and, with fixed exchange
rates, thus increase the relative price of an economy's
goods in world markets to the point that the goods
would lose their international competitiveness, ending
the trade surplus.
During the last few decades Taiwan accumulated a
large stock of international reserves, specifically dollars and gold. By mercantilist standards, their actions
would have to be judged quite successful.
While Taiwan was running a sustained balance-oftrade surplus, it restricted exchange transactions in
such a way as to channel reserves into the central bank.
Domestic holdings of foreign currency were restricted,
and all proceeds from exports were surrendered to the
6
Eco no m ic



Review

central bank, which controlled the exchange rate as a
managed float, or, before the mid-1980s, a fixed rate
against the U.S. dollar. The immediate consequence
of this institutional arrangement was that the central
bank monetized the trade surplus. A firm that exported goods (the trade surplus) would be paid in a foreign currency, then would take that currency to the
central bank and exchange it for domestic currency.
As a result, the central bank ended up with the international reserves yielded by the net export surplus.
The process generated a high rate of central bank
money growth.
Because inflation in prerevolution China was a substantial problem for the nationalist government then
on the mainland, the relatively rapid rate of money
growth was of concern to the nationalist government
of Taiwan. The central bank had to perform what
amounted to domestic open-market operations, selling
securities domestically (not international reserves) in
exchange for its previous money issue. In effect the
central bank was trading its domestic assets for international reserves. However, these operations were
conducted on such a large scale that the central bank
had to start issuing its own bonds (on which it paid interest) in exchange for foreign reserves (on which it
earned little).
More importantly, however, f r o m a theoretical
viewpoint, the central bank was simply trading one
form of its liabilities—central bank bonds—for another, central bank money, in an effort to control the
growth rate of the latter. The latter did not pay interest,
though, while the former did. Thus, the central bank
was trying to slow the rate of money growth by issuing bonds that promised to pay even more money
when the bonds matured. Serious issues of feasibility
appeared and had to be addressed.
Liberalization. On July 15, 1987, Taiwan lifted all
restrictions on current account transactions and up to a
net nontrade-related outflow of U.S. $5 million per
year and net inflow of $50,000, which increased with
time. In particular, firms no longer were required to
give up their foreign exchange earnings from trade, effectively meaning that the central bank was no longer
forced to monetize the trade surplus.
Later that year, on October 1, restrictions on foreign investment into Taiwan were lifted. The effective
investment intermediaries were commercial banks,
whose total foreign liabilities had been frozen at U.S.
$13.8 billion on May 31, 1987. During the day of the
liberalization these foreign liabilities increased by
more than 17 percent, resulting in an immediate deliberalization the next day.
November/December 1991

While the rather dramatic events of October 1 highlighted the desire of the rest of the world to invest in
Taiwan, in fact there was a substantial pool of savings
waiting to get out, too. As the Far Eastern Economic
Review reported at the time of the liberalization
("Opening the Floodgates" 1987), firms engaging in
trade had always had a standard set of devices, such as
under- or overinvoicing, to elude foreign exchange
controls. However, these options were not readily
available to individuals, so they had accumulated a
substantial pool of savings that were expected to start
flowing abroad quite soon. Indeed, in 1988 a capital
outflow of U.S. $4.9 billion occurred, and in 1989 an
outflow of U.S. $8.2 billion. The capital outflow for
1990 looks stronger still.
It is still relatively early to draw many serious longterm conclusions about the liberalization's effect on
the economy. Savings rates are down from preliberalization levels, but that result, in itself, conveys little
information: in 1987 gross national savings were
about 38 percent of GNP, which, by industrialized
economies' standards, seems unsustainably high. By
contrast, the United States has a gross national savings
rate of about 4 percent. Taiwan's savings rate has declined to approximately 28 percent of GNP, which is
still quite high. There are two possible explanations
for this decline.
First, the decline in savings may represent an increase in economic welfare. External investment opportunities may offer a higher risk-adjusted real rate of
return, and the expanded set of investment options
may allow more portfolio diversification, allowing for
higher real returns with little net addition to risk. As a
result of the larger opportunity set and greater diversification, the same net return from savings may be
achieved with a lower overall savings rate. It is still
too early to draw implications from postliberalization
data about the c h a n g e in d o m e s t i c i n c o m e f r o m
abroad. On the other hand, it could just be that the savings rate is returning to a more reasonable level.
The decline in savings did not initially adversely
affect capital formation rates (a measure of investment), which have climbed about 3 percentage points
as a fraction of G N P from the time of liberalization
through 1989 as measured in either gross or fixed
capital terms. Therefore, the s l o w d o w n in growth
since the liberalization—from almost 12 percent in
1987 to (a forecast o f ) slightly more than 6 percent
f i 9 9 i — c a n n o t necessarily be attributed specifically to a decline in capital formation resulting from the
liberalization. The growth rate of a relatively small
economy may be expected to be relatively volatile, as
o r

5

Federal Reserve Bank of



Atlanta

indeed Taiwan's has been, and the slowdown may not
be outside " n o r m a l " variations in the e c o n o m y ' s
growth. Moreover, by industrial economies' standards,
Taiwan is still growing at a very healthy pace. The
slowdown is nevertheless, and understandably, a major concern domestically ("Export Machine R e v s "
1991). It is also too early to tell whether this change in
capital formation is a permanent rate change or simply
a transitional effect resulting from the liberalization.
One clear consequence of the liberalization is a diminishing of the central bank's ability to influence
domestic real rates of interest. Earlier work (Rosemary Thomas Cunningham and Thomas J. Cunningham 1990; T.J. Cunningham and R.T. Cunningham
1991) has shown that prior to liberalization the Central Bank of China (Taiwan) had some influence over
the behavior of the domestic real rate of interest. After the liberalization, however, the effect disappeared.
This development is to be expected in a small, open
economy, for which movements in real rates in the
rest of the world force similar movements domestically.
Outside of immediate domestic considerations,
several longer-run concerns make liberalization desirable. Internationally, Taiwan's persistent and large
trade surpluses may annoy foreign political leaders to
the point that they erect some form of trade barrier.
Liberalization may not, by itself, address the tradebalance problem, but to the extent that a mercantilistlike accumulation of foreign assets is slowed, so too,
by definition, must the trade surplus diminish. Taiwan's trade surplus has fallen about one-third from
1987 (U.S. $18.6 billion) to 1990 (U.S. $12.2 billion),
with the shrinkage continuing into 1991. Domestically, large accumulations of savings denied access to international markets or constrained in rate of return by
domestic financial repression may result in domestic
political pressure for both international and domestic
liberalization.
6

Conclusion
Dramatic institutional reform, financial or otherwise, rarely happens outside of a substantial domestic
political or economic crisis. Taiwan's liberalization,
however, while accompanied by some relatively minor
political demonstrations, seems to be the consequence
of coming of age industrially. As such, it may provide
some relatively "clean" evidence regarding the consequences of financial liberalization.
Econom ic Review

7

Liberalization, as discussed, has some rather substantial benefits. Though it may not immediately serve
to increase economic growth, by expanding choice

sets and more efficiently allocating resources liberalization will likely increase economic welfare.

1. According to the State Department, the U.S. government no
longer refers to Taiwan as the "Republic of China." Taiwan,
however, still calls itself the Republic of China.
2. The Gini coefficient during that time was also cut by a third,
from 0.44 to 0.30. See Kuo (1983, 96-97). The larger issues
surrounding income distribution and growth are outside the
scope of this work. Readers interested in the topic should see
Phelps (1973) or Rawls (1971).
3. See Cunningham (1988) for a review of Nay lor that contains a taxonomy and discussion of capital flight motivation
issues.

4. Critics of the compensation approach to welfare analysis
point out that this criterion seems inappropriate because the
compensation is rarely made. Proponents respond that there
are winners and losers in virtually any economic event, and
some standard of welfare analysis needs to be made. More
recently, see Pollak (1991). In fact, the entire issue of the
Journal of Econometrics containing Pollak's article is devoted to welfare issues.
5. The 1991 forecast is from Republic of China (1990, 24).
6. The welfare benefits of reducing a trade surplus to mollify
major trading partners are unclear.

References
Bencivenga, Valerie R., and Bruce Smith. "Financial Intermediation and Endogenous Growth." Review of Economic
Studies 58 (1991): 195-205.
Burkett, Paul. "Financial 'Repression' and Financial 'Liberalization' in the Third World: A Contribution of the Critique
of Neoclassical Development Theory." Review of Radical
Political Economics 19, no. 1 (1987): 1-21.
Cho, Yoon Je. "McKinnon-Shaw versus the Neostructuralists
on Financial Liberalization: A Conceptual Note." World Development 18, no. 3 (1990): 477-80.
Cunningham, Rosemary Thomas, and Thomas J. Cunningham.
"Recent Views of Viewing the Real Rate of Interest." Federal R e s e r v e Bank of Atlanta Economic Review 75
(July/August 1990): 28-37.
Cunningham, Thomas J. "A Review of 'Hot Money and the
Politics of Debt'." The Bankers Magazine, January/February
1988, 74-77.
Cunningham, Thomas J., and Rosemary Thomas Cunningham.
"The Behavior of Real Rates of Interest in a Small, Opening
Economy." Journal of Economic Development 16, no. 1
(June 1991): 191-202.
"Export Machine Revs." Far Eastern Economic Review, June 6,
1991,52.

Econom ic
8



Review

Kuo, Shirley W.Y. The Taiwan Economy in Transition. Boulder, Colo.: Westview Press, 1983.
McKinnon, Ronald I. Money and Capital in Economic Development. Washington, D.C.: Brookings Institution, 1973.
. "Financial Liberalization and Economic Development: A
Reassessment of Interest-Rate Policies in Asia and Latin
America." Oxford Review of Economic Policy 5, no. 4 (1989):
29-54.
"Opening the Floodgates." Far Eastern Economic Review, July 23,
1987,52-54.
Phelps, E.S. Economic Justice. New York: Penguin Books,
1973.
Pollak, Robert A. "Welfare Comparisons and Situation Comparisons." Journal of Econometrics 50 (1991): 31-48.
Rawls, John. A Theory of Justice. Cambridge, Mass.: Belknap
Press, 1971.
Republic of China. Directorate-General of Budget, Accounting
and Statistics, Executive Yuan. Quarterly National Economic Trends, Taiwan Area, The Republic of China. November
1990.
Shaw, Edward S. Financial Deepening in Economic Development. New York: Oxford University Press, 1973.

November/December 1991

JEvaluating
Embedded Options

Hugh Cohen

The author is an economist in
the financial section of the Atlanta Fed's research department. He thanks David Heath,
Robert Jarrow, and Peter
Can for valuable discussions
on the wild card option.

Federal Reserve Bank of


Atlanta

n an effort to control interest rate exposure many banks, financial institutions, and investors are buying complicated financial instruments.
Many of these are difficult to understand (and thus difficult to value)
because of the embedded options they contain. This article discusses a
procedure that in some instances greatly eases the way that embedded
options may be valued: the technique is to value it as though it were separate from the financial contract. Treating the embedded option independently is desirable when it is accurate because it is usually simpler to ignore the
details of the surrounding contract.
In this article, two examples will be used to demonstrate this method.
The first is valuing the call option sometimes embedded in Treasury bonds
by separating the embedded option from the contract; for this option the
technique results in a correct value. The second example involves valuing
the wild card option (an option that allows a trader to sell a Treasury bond
between 2:00 P.M. and 8:00 P.M. at a price fixed at 2:00 P.M.) embedded in
Treasury bond futures contracts. In the latter case, separating the embedded
option leads to an incorrect value for it.
It is important to understand the procedure because many financial texts
mistakenly value the wild card option by separation, even though doing so
produces erroneous results. Additionally, callable Treasury bonds have been
mispriced although they could have easily been priced correctly by separation. The discussion that follows details ways to determine if the separation
technique can be correctly applied.
Econom ic Review

9

Callable Treasury Bonds
Callable Treasury bonds represent a significant portion of the Treasury bond market (which is composed
of Treasury securities with more than ten years to maturity when issued). In the fall of 1990, the Treasury
reported almost $100 billion in callable bonds outstanding, representing approximately one-fourth of the
total par value of Treasury bonds (Bulletin 1990).
The payment stream of a Treasury bond has two
parts. The bond's face value is the lump sum to be
paid at maturity, which is usually thirty years from the
date the bond is first issued. Semiannual coupon payments are made until the bond matures. A noncallable
Treasury bond has a fixed maturity, so its payment
stream is fixed. A call option gives its holder the right,
but not the obligation, to buy the underlying security
at a specified price, called the exercise price, over a
specified period, called the exercise period. A callable
Treasury bond gives the Treasury the right, but not the
obligation, to accelerate the bond's maturity at any of
the coupon payment dates during the five-year period
before the original maturity date, provided that bondholders are given four months notice. When a Treasury bond is called, the Treasury pays the bearer the
face value payment and a final coupon payment, and
the Treasury is released from obligations to make later
coupon payments.
The embedded call option becomes valuable for the
Treasury to exercise when the bond's coupon rate is
higher than the prevailing interest rate. In this scenario
the Treasury can call the bond and refinance the debt
by issuing a new one at the current, lower interest rate.
Thus, after the call-protection period, investors in
callable bonds risk losing their coupon payments at a
time when interest rates are lower than coupon rates.
Furthermore, if the coupon rate is lower than the prevailing interest rate the Treasury will not exercise the
option, and the bondholder will be forced to continue
receiving the lower coupon rate.
For the first time since December 1962, the Treasury called a bond on October 9 of this year. With interest rates at approximately 5 percent, the Treasury
called $1.8 billion of callable Treasury bonds. The
called issue w a s the A u g u s t 1 9 9 3 b o n d , w i t h a
coupon rate of 7.5 percent. (The next, and now final,
coupon payment will be on February 15, 1992, because the Treasury gave the required four months' notice.) R e f i n a n c i n g the d e b t s a v e d the T r e a s u r y
approximately $18 million. At the same time it was
called the bond was trading at $101.41 per $100 of

10


Eco no m ic Review

face value, a surprisingly high price for a bond that
could be called at face value (Wall Street
Journal,
October 10, 1991). This premium was possible partly
because of disbelief by the market that the Treasury
would call any bond after nearly three decades of not
doing so. For whatever the reason, this callable Treasury bond was clearly mispriced.
Determining a Callable Treasury Bond's Value.
One approach to determining the value of a callable
Treasury bond is to begin by valuing the embedded
call option as though it were stripped from the Treasury bond. Subtracting the value of this stripped call
option from that of an otherwise identical but noncallable Treasury bond yields the proper value of the
callable Treasury bond. To determine that they are
comparable, the cash flows of the two portfolios must
be analyzed and shown to be identical.
In the thirty-year callable bond described here, the
first fifty coupon payments are guaranteed by the callprotection period. The final ten coupon payments may
or may not be paid, depending upon whether the Treasury decides to exercise its call option, resulting in
eleven possible payment streams (outlined in Chart 1).
There are also eleven possible payment streams to the
portfolio of a long, noncallable Treasury bond with
one short call option on the final ten coupon payments
and the payment of face value at maturity, with an exercise price equal to the face-value payment, as shown
in Chart 2. (The investor who purchases an option is
said to hold the contract long. An option's seller is
said to hold the contract short.)
Because the cash flow of a callable Treasury bond
and the cash flow of the portfolio composed of buying
a noncallable Treasury bond and selling a separate call
option on the payments during the call period are identical for every possible date on which the Treasury
may exercise the call option (compare Charts 1 and 2),
the value of the two portfolios must be identical to
avoid arbitrage. If the two portfolios had different
prices, shorting the higher-priced portfolio and longing the lower-priced portfolio would capture the difference in prices without taking any risk. Thus the
embedded call option in the callable Treasury bonds
may be valued as a separate contract.
For example, the value of a $100 callable Treasury
bond that will mature between August 15, 2007, and
August 15, 2012, with a coupon rate of 8 percent can
be calculated from the following portfolio of securities: the value of a $100 noncallable bond maturing on
August 15, 2012, with a coupon rate of 8 percent is
$109.00. The value of a call option on the payments
occurring over the final five years of this noncallable
November/December 1991

bond with an exercise price of $100.00 is $5.25. The
noncallable bond's value less the value of the option is
the value of the callable bond—$103.75. As will be
demonstrated, not all embedded options can be accurately valued in this way.

The Wild Card Option in
Treasury Bond Futures
The Treasury bond futures contract traded on the
Chicago Board of Trade (CBOT) is a heavily traded
contract that contains many embedded options. One
of these, the wild card option, is an example of an option that cannot be priced by being examined separately from the contract. Before discussing the embedded
option, the following section first reviews the Treasury bond futures contract as it is traded on the CBOT.
The Treasury Bond Futures Contract. Upon entering a futures contract, the long trader, who will buy the
1

underlying security, and the short trader, who will sell
the underlying security, agree upon a futures price that
will be used to calculate future cash flows. Although it
can be entered into without cost, a futures contract obligates its traders to perform a series of future cash
flows. The values of these cash flows are a function of
the contract's settlement price, which is set by the settlement committee of the exchange at the close of
trading (2:00 P.M.) to reflect the futures contract's market value at that time. After the settlement price is determined, every position in the futures contract is
"marked to market." For an established long position
in the futures contract, the value of the cash flow of
marking to market is today's settlement price minus
the previous settlement price. The cash flow for an established short position is minus one times the value
of the cash flow of the long position. For a long position opened in the last trading session, the value of the
cash flow of marking to market is today's settlement
price minus the futures price when the position was
taken. This value times minus one is the value of the

Chart 1
Cash Flow of a Callable Treasury Bond
Called at the Fiftieth Coupon Payment
Semiannual
C o u p o n Payment
Number
Cash Flow

1

2

3

+CP

+CP

+CP

4

. . .

+CP.

.

48
.+CP

49

50

51

+CP

+CP
+FVP

0

52 . . .

59

60

. 59

60

0

Called at the Fifty-first Coupon Payment

Semiannual
C o u p o n Payment
Number
Cash Flow

1

2

3

+CP

+CP

+CP

4

. . .

+CP.

.

48
.+CP

49

50

51

+CP

+CP

+CP
+FVP

52 . .
0

.

.

.

0

0

59

60

+CP

+CP
+FVP

Not Called
Semiannual
C o u p o n Payment
Number
Cash Flow

1

2

3

4

+CP

+CP

+CP

+CP

Digitized Federal Reserve Bank of
for FRASER


.

+CP= C o u p o n Payment
+FVP= Face V a l u e Payment

Atlanta

Econom ic Review

11

Chart 2
Cash Flows of the Portfolio of One Long Noncallable Treasury Bond
And One Short Call Option on the Callable Payments
With an Exercise Price Equal to the Face Value of the Bond
W h e n the Option Is Exercised at the Fiftieth Payment
Semiannual
Coupon Payment

Cash Flow

. 59

60

. 49

50

51

52 .

.

. +CP

+CP

+CP

+CP .

.

,+CP

50
51
I
1
I
+FVP - C P

52 .

.

. 59

60

-CP.

.

.-CP

-CP

Number
1—
+CP +CP

+CP

+CP.

Long, Noncallable
Treasury Bond

+CP
+FVP

Semiannual
Coupon Payment
Number
Cash Flow

2

1

3

4

.

.

. 49

I
0

.

.

.

0

0

0

1

2

3

+CP

+CP

+CP

0

Short Option
Exercised at Fiftieth
Payment

— FVP

Semiannual
Coupon Payment
Number
Cash Flow

.

.

. 49

50

51

+CP .

.

. +CP

+CP

0

4

.

52 .
0

.

. 59
I

.

.

0

60
I

Resulting
Portfolio Cash Flow

0

+FVP

W h e n the Option Is Exercised at the Fifty-first Payment
Semiannual
Coupon Payment
Number

2

3

+CP

+CP

+CP

1

2

3

1
1 '

Cash Flow

4
i

. . .

+CP .

50
I

51
i

52
I

.

. +CP

+CP

+CP

.

. 50

51

52

53 . . .
I

59
I

60
! ...

+CP.

.

. +CP

+CP
+FVP

53 .
I

..

. 59

60

-CP.

.

I
.-CP

I
-CP

Long, Noncallable
Treasury Bond

Semiannual
Coupon Payment
Number
Cash Flow

0

0

0

1

2

3

+CP

+CP

+CP

4
0

.
.

.

.

I

0

+FVP - C P

Short Option
Exercised at Fifty-first
Payment

-FVP

Semiannual
Coupon Payment
Number
Cash Flow

Econom ic
12



Review

51

.

.

. 50

+CP .

.

. +CP +CP
+FVP

4

52
0

53 .
0

.

.

. 59

.

.

0

60

Resulting
Portfolio Cash Flow

0

November/December 1991

Chart 2 (continued)
W h e n the Option Is Not Exercised
Semiannual
Coupon Payment

.49

Number
Cash Flow

+CP

+CP

+CP

1

2

3

50

51

52 .
+CP.

+CP .

.

.+CP

+CP

+CP

.

.

. 49

50

51

52 .

. 0

0

0

51

+CP

+CP

. 59

.

1—
. +CP +CP

..

. 59

0 .

50

.

60

Long, Noncallable
Treasury Bond

+FVP

Semiannual
Coupon Payment
Number
Cash Flow

4

0

0

0

0

1

2

3

4

+CP

+CP

+CP

60
1

0

0

59

60

Short Option
Not Exercised

Semiannual
Coupon Payment
Number
Cash Flow

. . .

+CP.

.

49
. +CP

cash flow of marking to market a new short position.
Thus, a short trader profits when the settlement price
decreases from the previous day, and a long position
profits when the settlement price increases from the previous day. Additionally, the settlement price is used to
determine the delivery price for contracts when the delivery process is initiated on that day.
To understand marking to market, consider a trader
w h o enters a futures contract at a futures price of
$100. At the end of the trading session the settlement
price is $102. Because of marking to market, a long
trader would receive $2, and a short trader would pay
$2. If at the end of the next trading session the new
settlement price were $101, a long trader would pay
$1, and a short trader would receive $1. If at the end of
this last trading session a short trader initiated the delivery process, the price that the long trader would pay
to the short trader for the Treasury bond would be calculated using the $101 settlement price.
The short trader has many delivery options, a few
of which will be detailed here. The quality option
gives the short trader the right to deliver any $100,000
U.S. Treasury bond, provided it has at least fifteen
years remaining until maturity, if the bond is noncallable, or has at least fifteen years to its first call date

Federal Reserve Bank of


2

Atlanta

52 . . .
+CP.

.

.+CP

Resulting
Portfolio Cash Flow

+CP
+FVP

if it is callable. The short trader also has a timing option—the option to deliver the underlying Treasury
bond on any business day during the delivery month.
Additionally, the short trader has what is known as the
wild card option. When the market closes, the settlement committee meets and establishes the settlement
price for that day at approximately 2:00 P.M. (central
standard time) and marking to market occurs. During
the delivery month, the short trader has until 8:00 P.M.
to decide whether to initiate the delivery process and
to receive an invoice amount calculated using the 2:00
P.M. settlement price. Specifically, the short trader may
wait until 8:00 P.M., monitoring bond markets, and
then decide to deliver on the futures contract, receiving for the bond an amount calculated using the 2:00
P.M. settlement price. If the short trader decides not to
initiate delivery, this same scenario is repeated the following business day until the final settlement price is
posted. With the posting of the final settlement price,
the wild card option expires.
Valuing the Wild Card Option. Determining the
value of the wild card option embedded in the Treasury bond futures contract involves several questions.
How much is it worth to the short trader to be allowed
to wait until 8:00 P.M. to initiate the delivery process at
Econom ic Review

13

the 2:00 P.M. settlement price? Suppose the option is
removed from the futures contract. How much would
someone not involved in the Treasury bond futures
contract pay for a series of options permitting, until
8:00 P.M. for a Treasury bond to be sold at a price set
at 2:00 P.M.? Clearly, the option has value. If Treasury
bond prices decreased significantly between 2:00 P.M.
and 8:00 P.M., the bonds could be purchased at the new
lower price and sold at the higher price, resulting in a
profit. Alternatively, if Treasury bond prices rose over
the six-hour period, the option would not be exercised,
in favor of waiting until the next day when there
would be another opportunity. This process could continue until the option expired. Thus, as an option separated from the futures contract the wild card option's
Table 1
The Value of Separated and Embedded Wild Card Options
Embedded

Separated

Plays Remaining1'

W i l d Card

W i l d Card

W i l d Card

1

.199

.026

.312

3

.033

.371

4

.037

.421

5

.043

.454

6

.045

.486

7

.050

.528

8

.054

.559

9

.056

.590

10

.058

.612

11

.060

.627

12

.062

.653

13

.063

.666

14

.065

.680

15

.067

.697

16

In dollars,

.017

2

a

.068

.700

with a standard

error of one cent. For comparison

futures price of the futures contract
b

3

The number
card

of business

is approximately

purposes,

the

$88.

days left for the short trader to exercise

the

wild

option.

value comes from the opportunity to exercise the option when Treasury bond prices decline during the sixhour period.
However, it is incorrect to value the option embedded inside the futures contract in this way. Exercising
the wild card option has the additional consequence of
closing the futures contract position. After the wild
card option has been exercised, the Treasury bond is
 14


Eco no m ic Review

sold from the short trader to the long trader, and the
contract is fulfilled. It should be kept in mind that the
wild card option belongs to the short trader of the
Treasury bond futures contract, w h o profits f r o m
marking-to-market p a y m e n t s when the settlement
price declines. As discussed, the value of the separated
wild card option comes from the opportunity to exercise the option when Treasury bond prices decline
drastically between 2:00 P.M. and 8:00 P.M. However,
if a short trader exercises the wild card option in this
scenario, closing the position, the next marking-tomarket payment is not made. Given that bond prices
have decreased drastically, the lost marking-to-market
payment appears to be a profitable opportunity sacrificed by exercising the wild card option. Thus, to value the wild card option embedded inside the futures
contract the short trader must consider that exercising
the wild card option may result in closing a profitable
futures position. This fact is not taken into account in
valuing the wild card option separately because the
option's holder has no short position in the futures
contract and thus would not be involved with markingto-market payments.
Including the consequence that exercising the wild
card option will close the futures contract position
changes not only the value of the wild card option but
the conditions under which it will be exercised. An investor may not exercise the wild card option embedded inside the futures contract, even though it results
in a large positive cash flow if the marking-to-market
cash flow is believed to be larger. Furthermore, an investor may exercise the wild card option when the
cash flow is negative to avoid an even larger expected
loss from the marking-to-market payment.
Clearly, a wild card option separated from the futures contract is of an entirely different nature than
when it is embedded inside the futures contract. However, analyzing embedded options by separation, even
though it may be inappropriate, is quite c o m m o n .
Contributing to this tendency is the fact that most
textbooks discussing the wild card option of the Treasury bond futures contract actually discuss the separated wild card option, as in the following passages:
"Occasionally, news that causes a significant fall in
the value of bonds can occur after the market closes,
but before the deadline for announcing plans to deliver. The short trader can then announce the intention to
deliver, thereby locking-in the settlement price for
that day, a price that does not reflect the bearish information for bonds. The next day, the bond will open at
a lower price, and the short trader simply acquires the
n o w c h e a p e r b o n d for delivery at the old higher
November/December 1991

price" (Robert Kolb 1988, 198). The idea that the
next marking to market will also be profitable is not
addressed. Another example exactly matches the description of a wild card option separated from the futures contract: "Restricting attention to a particular
deliverable bond whose invoice price is (fixed) at the
2:00 P.M. settlement price, the short effectively holds
a put option on the bond (with an exercise price equal
to the invoice amount of the bond) which expires at
8:00 P.M. Since there are actually many deliverable
bonds, the wild card option is somewhat more complicated, as well as somewhat more valuable" (Darrell
Duffie 1 9 8 8 ) .
Mispricing the wild card option can be costly to investors in two different ways. First, investors may exercise the option at times that are less than optimal
because they have not taken into account the full effects of exercising it. Second, by separating the embedded option investors may agree to an incorrect
futures price when they enter the contract. Valued as
an embedded option the wild card option is worth significantly less than as a separated option, as shown in
Table 1. Table 1 presents the results of a simulation
run to value both the embedded and the separated wild
card option by simulating the change in interest rates
during the six-hour period when the option may be exercised. (See the appendix for a more detailed discussion of the simulation.) In the simulation, separating

A computer simulation was performed to observe the
difference in value between the wild card option embedded in the Treasury bond futures contract and a wild
card option separated from the contract. The term bit J )
is defined as the price at time t of a default-free zerocoupon bond that pays one dollar at its maturity, time T.
It is assumed that, at any fixed point in time, prices exist
for all possible zero-coupon bonds. Further, f(t,T) is defined as the instantaneous forward interest rate at time T
as seen from time t: f(t,T) is the forward interest rate
that one could contract for at time t on a default-free
loan during the forward period [T,T + dT]. To avoid arbitrage, there exists the following relationship between
bond prices (assuming the prices are smooth) and the
forward rate curve:

b(t,T) = exp [— f
?

f{t,ix)dfx\.

T

Thinking of each payment of a Treasury bond as
its o w n zero-coupon bond implies that noncallable
Treasury b o n d s m a y be priced as the sum of zeroDigitizedFederal Reserve Bank of
for FRASER


Atlanta

the wild card option from the Treasury bond futures
contract results in an option worth approximately ten
times that of the embedded option. It should be clear
that separating the option from the futures contract
does not properly value the embedded option.

Conclusion
Two examples have been presented to illustrate a
problem in valuing embedded options. Often, the process used does not value the embedded option but
rather, because it is simpler to calculate, a similar option separated from the contract. The separated option's value may or may not be equivalent to the
embedded option's. In callable Treasury bonds the
separated and embedded call options have equal value. In Treasury bond futures contracts, however, the
embedded wild card option is worth considerably less
than the separated one. Thus, when comparing the
separated and embedded options, it is important to
determine that all implications of exercising the embedded option match those of exercising the separated option. Specifically, all cash flows of one must
match the cash flows of the other. Otherwise, the embedded option may be an entirely different security,
and valuing it incorrectly could prove to be costly.

coupon bonds. Thus the prices of noncallable Treasury bonds can be calculated from the forward interest rale curve.
For the purpose of the simulation, it is assumed that
the forward rate curve's fluctuation over time was according to the Heath, Jarrow, and Morton continuous
time constant model, which was chosen because of its
simplicity. This model assumes changes in the forward
rate curve over time to be random parallel shifts (with
the inclusion of a small correction term to make the
model arbitrage-free), such that
1

d f { t j ) = adW(t) +

a(t,T)dt,

where
(x(t,T) = <r t(T
2

The term a is the constant volatility over the entire forward rate curve, W(t) is a standard Wiener process, and
a is a function necessary to avoid arbitrage. Typically, a

Econom ic Review

15

Appendix

(continued)
Once the values of both wild card options were determined at the point of having one exercise period remaining, the values at the settlement time with two wild card
plays available were calculated, assuming that the option
was exercised only if the payoff was greater than the expected payoff with one wild card play remaining. Working backward in this manner, the values of both wild card
options were calculated over the entire delivery month.
A standard deviation of .02 was used as the annual
standard deviation in the forward rates. The bonds used
and their c o n v e r s i o n f a c t o r s were taken f r o m Kolb
(1988) as the bonds available for delivery on June 1,
1987. In addition, the following initial stepwise forward
rate curve was used for each run of the simulation:

is very small. The faet that the change in the forward rate
curve is independent of the value of the initial forward
rate curve means that negative forward rates are possible
in the future, even if the initial forward rate curve is
strictly positive. However, this forward rate model was
chosen because small parallel shifts in the forward rate
curve seem reasonable over the six-hour period during
which the wild card option may be exercised.
The simulation started at the settlement time, with
one wild card play remaining, and the change in the forward interest rate curve was calculated from 2:00 P.M. to
8:00 P.M. using the continuous time constant model of
Heath, Jarrow, and Morton. At 8:00 P.M. the values of
both wild card options were computed from the simulated forward rate curve. The calculation of the separated
wild card option's value is straightforward, being simply
the difference between the value of payment received
for the bond calculated from the 2:00 P.M. settlement
price and the current 8:00 P.M. bond price. To do the
more complicated calculation of the value of the embedded wild card option, the upper bound as detailed by
Hugh Cohen (1991) was used.

fw(0, 0.25, 0.5, 1, 5, 10, 35) = (0.076, 0.079, 0.082,
0.087, 0.089, 0.09, 0.09).
The values of the two wild card options are given in
Table 1 as a function of the number of business days remaining for the short trader to exercise the wild card
option.

2

1. For a complete explanation of this model see Heath, Jarrow, and Morton (forthcoming).
2. In Cohen (1991), under the assumption of the existence
of an unique equivalent martingale measure, a theoreti-

Notes

1. According to the Wall Street Journal, the open interest was
more than 260,000 on July 11, 1991. Because each futures
contract is on a $100,000 face value U.S. Treasury bond, the
collective face value of the open interest is S26 billion.
2. The actual invoice amount depends on which Treasury bond
the short trader chooses to deliver. Every possible deliver-

cal upper bound for the value of the wild card option is
established. This upper bound is used as the value of the
wild card option in the simulation.

able bond (the terms of which arc defined later) has a factor
that is multiplied by the settlement price. This product plus
the accrued interest of the delivered bond is the amount paid
by the long trader to the short trader.

References
Bulletin of the United States Treasury, Fall 1990.
Cohen, Hugh. "The Wild Card Option in Treasury Bond Futures Is Relatively Worthless." Federal Reserve Bank of
Atlanta Working Paper 91-13, November 1991.
Duffie, Darrell. Futures Markets. Englewood Cliffs, N.J.:
Prentice Hall, 1988.

16



Eco nom ic Review

Heath, David, Robert Jarrow, and Andrew Morton. "Bond
Pricing and the Term Structure of Interest Rates: A New
Methodology for Contingent Claims Valuation." Econometrica (forthcoming).
Kolb, Robert. Understanding Futures Markets. Glenview, 111.:
Scott, Foresman and Company, 1988.

November/December 1991

FYI
Prospects for
Energy Supplies

Gene D. Sullivan

The author is a retired research officer in the Atlanta
Fed's research department.
He thanks Frank King and
Mary Rosenbaum for their
contributions to the article.

Federal Reserve Bank of Atlanta


nergy costs and availability are national and international concerns/Oil shocks such as the embargoes in the 1970s and recent
hostilities in the Persian Gulf have taught users and policymakers
that both the quantity and price of energy, especially oil, significantly affect standards of living. In the light of price changes associated with these shocks it has become clear that there are additional supplies
of oil and a variety of alternative energy sources that could be exploited in
the event of increases in the real price of oil that are expected to persist.
Because continuing use is likely to diminish the world's oil reserves, or
at least force use of reserves with more expensive extraction costs, a number
of experts anticipate a long-term tendency for prices of oil and other energy
sources to rise whether there are supply shocks or not. Further exploitation
of potential oil and other energy sources is likely to limit future price increases and may well influence current output and pricing decisions of the
Organization of Petroleum Exporting Countries (OPEC) cartel. The array of
energy sources that could be available at higher prices is broad and not always fully understood. This article presents an inventory of these sources
and attempts to present unit-cost-of-production data when available.
Costs of production are explicitly considered in order to provide some
sense of which of these alternatives might come into play first if oil price increases that were expected to persist occurred. It should be kept in mind that
this cost information is not very satisfactory because the range of costs for
each alternative under consideration is quite wide and would depend on
variables such as location, necessary technology, and environmental problems. Rather than any one alternative dominating the market, it is most likely that several would be used at the same time, with the mix determined by
the lowest cost when all factors are taken into account.
Econom ic Review

17

.Short-Run and Long-Run
Price Influences
The relationship between a product's price and the
amount supplied and demanded in the short run almost
always differs from that relationship over longer periods because during longer periods opportunities for
adjustments in consumption and production patterns
can be substantial. Such adjustments take time because they require investment in production, distribution, or use facilities. In turn, once that investment is
made the new facilities and patterns are likely to continue in use as long as variable costs are covered.
In the very short run, demand for oil shows little
sensitivity to price changes because few immediate
options are available to energy users (see William C.
Hunter and Mary S. Rosenbaum 1991). Price sensitivity increases as time passes because a number of alterative energy sources or means of conservation can be
adopted.
The sensitivity of oil supply to price may also increase over time—quantity at a given (now higher)
price may increase—owing to a number of factors.
For instance, investment in exploration and production drilling can eventually increase output from new
oil fields. Applying existing technologies to wider areas can increase the amount of oil recovered from
known deposits. New technologies may be developed
and dispersed as well, in response to prices that increase the potential profit rewards to developments.
Time also opens possibilities that political restrictions
on exploration or production can be altered or removed.
Another potential reaction to higher oil prices is an
increase in supplies of oil substitutes. Coal, alcohol
f r o m biomass, natural gas, and nuclear energy are
clearly substitutes in some uses, though each has its
drawbacks. Commercial quantities of wind and solar
energy are also being developed as alternatives. Clearly, the projected permanence of current price levels
will strongly influence overall supply changes.
However, factors that would tend to raise the costs
of some energy sources relative to oil may also affect
their viability. For example, external costs such as
those involved in abating the environmental pollution
that frequently accompanies coal usage add to the
cost structure specifically of coal and of overall energy supplies. As these external costs are increasingly
recognized, especially in the United States, they can
significantly influence the total costs of placing a
product on the market.
 18


Eco no m ic Review

.Expanding Oil Supplies
Oil, the dominant energy form in commercial use,
is the most likely source of substantial additional energy supply for the world market, at least in the next
decade. Availability will be an important factor. In the
1980s the quantity of proved reserves actually expanded in relation to oil production, as shown in Tables 1
and 2. All reserves do not have the same extraction
costs, however, and a number of the newly identified
reserves will be more expensive to extract than those
counted in earlier years. Rising prices are also likely to
contribute to increased oil production. OPEC actions
have helped raise prices, and prices of oil in real terms
have increased consequently. At the same time that an
increase can be expected in the quantity of oil produced at higher prices, it is possible that political barriers blocking exploration could be reduced, resulting
in discovery of some oil extractable at less than current average costs.
Exploratory Oil Drilling. New exploration activity for oil and gas offers the most immediate possibilities for extending energy supplies. Such drilling has
typically been an economical means of enlarging the
quantity of usable energy. Sustained price increases
would make it likely that enough economic potential
would be perceived to draw capital and technology
even to remote locations.
Various constraints have limited exploration in the
major areas of the world believed to hold the most
promise for new petroleum discoveries. In the area
historically known as the Soviet Union and in China
and Alaska political restrictions of various sorts have
hampered exploration; in the vast deep-water areas of
the continental shelves, technological limitations
have, until recently, prevented drilling.
Despite the Soviet Union's position as the largest
single producer of crude oil since the mid 1970s, Soviet production has remained flat since 1980. Siberia is
considered an especially good prospect for discovery
of substantial oil reserves, similar to the Prudhoe Bay
in northern Alaska. The lagging investment and lack
of technological know-how for drilling in harsh climates that has limited Soviet exploration activity in recent years is likely to be turned around now that the
potential for large finds to be sold at the higher prices
promises a sufficiently low unit cost to make new explorations attractive. In addition, joint ventures with
the more capital-rich and technologically advanced
western oil companies make significant new discoveries in the coming decade increasingly likely.
1

November/December 1991

Table 1
Crude Oil Production
By Principal Country and Region
(percentage

of world total)

1938

1950

1960

1970

1980

1985

1989

63.4

54.6

37.2

24.9

20.2

24.6

19.3

0.8

2.5

2.7

2.4

2.7

2.2

1.9

1.3

1.1

3.3

5.2

4.3

61.1

51.9

33.5

21.1

14.5

16.7

12.7

13.2

16.9

16.5

10.4

6.1

6.7

6.6

0.4

0.4

0.3

1.1

1.0

North America
Canada

0.4

Mexico

1 -9

United States
South America

0.01

Brazil

NA

Venezuela

9.5

14.4

13.6

8.1

3.7

3.1

3.2

10.5

7.2

14.0

15.3

19.3

21.0

20.2

0.2

0.7

1.3

0.7

4.1

6.9

6.3

NA

NA

NA

NA

0.9

1.4

2.6

NA

0.01

0.01

0.0

2.7

4.7

2.9

0.1

0.4

1.4

13.3

10.3

10.0

10.1

NA

0.9

2.3

1.9

1.9

1.9

0.4

0.3

0.7

1.0

1.7

1.5

USSR
Western Europe
Norway
United Kingdom
Africa
Algeria

NA

Egypt

0.1

Libya

NA

NA

NA

7.3

3.0

2.0

2.3

Nigeria

NA

NA

0.1

2.4

3.5

2.8

2.7

6.0

16.9

25.0

30.6

31.1

19.3

26.7

6.4

5.0

8.4

2.8

4.2

4.8

1.3

4.6

3.4

4.2

2.7

4.6

3.3

7.7

6.5

2.8

1.9

2.7

5.3

5.9

8.3

16.7

6.3

8.1

NA

1.7

2.9

2.2

3.2

8.2

10.7

10.3

3.6

4.7

4.6

M i d d l e East
Iran

3.9

Iraq

1-6

Kuwait

NA

Saudi Arabia

0.03

United Arab Emirates

NA

NA

3.9

2.3

3.1

3.9

0.02

0.5

0.9

2.0

1.9

2.7

2.2

2.4

7.7

16.7

21.8

19.6

21.9

Far East
China

NA

Indonesia

2.9

1.3

2.0

3.8

Total W o r l d
(Billions of barrels)

Source:

Twentieth

Century

Petroleum

Statistics

(1990).

Exploration in China has also been limited, primarily for political reasons. China promises to yield major finds once the country is opened to the use of
modern technology. More intensive exploration in
China during the past two decades has led to a doubling of crude oil output since 1975 and a tenfold increase since 1968. Even so, Chinese production still
accounts for only about 5 percent of the world's total
Federal Reserve Bank of



Atlanta

and, as of 1990, known reserves were less than 2.5
percent of the total.
Vast areas of the South China and East China seas
are the largest unexplored o f f s h o r e basins in the
world. Exploration to date has yielded only marginal
results, with the exception of one large natural gas
field, but the areas of China, both on- and offshore, are
considered promising. The possibilities for foreign
Econom ic Review

19

Table 2
Crude Oil Reserves by Principal Country and Region
Beginning of Year
(percentage

of world total)

1952

1970

1980

1985

29.1

North America

1960
13.3

8.3

10.2

12.0

Canada

1.5

Mexico

1.3

United States

26.2

1.6
0.9

1.7
1.1

1.0

0.6

4.9

6.9

5.6

4.2

4.1

2.6

5.0

6.9

0.3

0.2

5.6
4.4

3.9

0.8

0.4
2.8

3.7

5.8

10.4

9.0

5.Í
1.9

9.9

7.5

Argentina

0.0

0.7

8.6

6.2

2.8

NA

NA

NA

Venezuela

1.1

10.9

South America

USSR

1990

0.4

3.6

3.5

Norway

NA

NA

NA

0.9

1.2

United Kingdom

0.0

0.0

0.0

2.4

1.9

0.4

8.9

7.9

5.9

1.3

1.3

Western Europe

0.5

0.5

1.1

0.2

3.0

0.0

0.9

2.7

2.4

1.6

62.3

62.7

56.3

56.9

65.9

0.0

3.0

4.4

4.4

9.2

12.0

10.4

9.0

9.5

8.6

5.2

14.3

Iran

3.7

14.8

A b u Dhabi

6.6

NA

M i d d l e East

0.5

51.0

Nigeria

1.5

NA

Libya

10.3

1.7

NA

Algeria

2.5

NA

Africa

21.3

12.8

Iraq

4.8

6.9
6.4

0.9
2.3

9.3

10.0

12.9

0.6

0.5

17.2

1.0
26.4

25.4

24.1

25.5

1.9

Neutral Z o n e

10.2

11.4

Kuwait

3.5

2.5

6.1

5.4

4.6

0.4

0.5

0.7

1.5

1.2

0.8

3.1

2.7

2.4

642.2

699.8

1,001.6

NA

Qatar

1.1

Saudi Arabia
Asia-Pacific

0.0

India

NA
0.9

0.2

1.2

China
Total W o r l d

3.1

NA

Indonesia

NA

105.0

291.3

2.4

0.1
1.7
NA
530.7

1.0

0.8

9.4
0.5
0.4

(Billions of barrels)

S o u r c e : Energy Statistics

Source

Book (1990).

participation in o f f s h o r e exploration increase its
potential.
In the United States, the National Wildlife Management Area of northern Alaska has also been closed to
exploration. This area is believed to hold crude oil reserves more or less equal to the massive find in Alaska's
20


Econo m ic Review

Prudhoe Bay field. Concerns for protecting wildlife and
the environment have thus far been sufficient to prevent exploration in this preserve. Supply disruptions
more severe than are now foreseeable would probably
be required to induce opening that region for exploratory drilling. Nonetheless, this region's potential
November/December 1991

still hangs over the oil market and may well influence prices.
The remaining additional possibilities for major
crude oil discoveries require the use and continued development of new, now relatively expensive technologies to explore the deep-water shelf areas surrounding
the continental land masses. The spread of drilling
technology allowing wells in water depths greater than
1,000 feet will no doubt yield additional reserves in
the North Sea as well as in other locations such as the
Gulf of Mexico, the shelves along both the Atlantic
and Pacific seaboards of North America, and the seas
along the continent of Asia already mentioned.
Deep-water drilling, however, costs substantially
more than shallow-water drilling. For example, in
1988 the average offshore drilling cost in the United
States was $289 per foot for wells averaging 10,800
feet deep, versus $70 per foot for wells averaging
5,050 feet in depth (Twentieth Century
Petroleum
Statistics 1990, 92-93).
D e e p - w a t e r explorations are likely to proceed
rather slowly until oil prices move well above the recent levels (about $20 per barrel) and show convincing evidence of remaining elevated. A producing
well near the 2,000 foot depth level in the Gulf of
Mexico was closed down in 1990 because of mechanical difficulties, and further deep-water drilling at the
site was halted, reportedly because of unprofitable
production at existing and expected prices (Rick Hagar 1990, 30).
Expanding Existing Wells' Output. New technologies are enhancing oil producers' ability to expand output f r o m existing wells. Both horizontal
drilling and a set of techniques called enhanced oil recovery, which involves injecting various substances
into a well to increase accessibility of residual deposits, are proving successful means of further developing known oil fields.
Horizontal Drilling. Horizontal drilling, a relatively new technology, allows the lowest per barrel recovery costs of all drilling methods in certain types of
existing fields such as the geological formations of the
West Texas chalk, where oil is held in vertically configured reservoirs. Vertical drilling into a particular
reservoir may fail to tap into oil reserves that have
drained elsewhere. By drilling at acute angles from the
vertical shaft for distances of several thousand feet, reserve pockets that would otherwise be unavailable can
be perforated.
While horizontal drilling techniques are more costly
per foot of drilled well, they frequently produce more
oil than vertically drilled wells. Costs of horizontal
DigitizedFederal Reserve Bank of
for FRASER


s

Atlanta

drilling may range from 40 percent higher to several
times the cost of a vertical well. However, output from
a horizontal well may also range from three to five
times greater than the output from a vertical well. On a
per barrel basis, drilling costs can be cut by one-third
or more per barrel in some fields. This potential cost
advantage explains the growing popularity and rapid
adoption of the technique during recent years.
Currently, horizontal drilling has appeal for easy
applications. The technique is expected to spread to
more difficult applications as producers gain experience and techniques are improved. Its use will probably expand to some older fields outside the United
States as well, unless opening new fields keeps oil
prices so low that the more costly horizontal drilling
technique is uneconomical.
Petroleum experts agree that new fields of major
importance are not likely to be found by horizontal
redrilling of vertical wells. Because of its higher cost,
it is doubtful that horizontal drilling will be used to explore new areas.
Enhanced Oil Recovery. In addition to using horizontal techniques, oil producers have succeeded in exp a n d i n g output f r o m existing wells by injecting
various substances, such as water, steam, or carbon
dioxide, into a well to make a greater proportion of
residual deposits accessible for pumping. The bundle
of techniques used for this procedure is referred to as
enhanced oil recovery (EOR). The relatively recent
c o m m e r c i a l a p p l i c a t i o n of this t e c h n o l o g y h a s
achieved significant output increases in older wells
generally known as secondary or stripper wells. One
major company reported that more than half its domestic crude and condensate production in 1985 came
from EOR ("Oil Field Chemicals" 1986). Although
the drop in oil prices in the mid-1980s led to reductions in E O R production, the technique remains a
promising source of future expansions in oil output.
Continuing development should make EOR even
more efficient. A relatively new technique is microbial
stimulation, in which producers inject microorganisms
and nutrients into a dormant well. Following injection,
generation of gases that accompany microbial growth
adds pressure, which aids oil recovery. The treated
well is then returned to production, and the injection
cycle is repeated when production falls off again. The
technique is appealing both because it costs less than
other EOR techniques and because microorganisms
produce a number of by-products that enhance future
oil recovery. In addition, microorganisms remove sulphur and nitrogen-containing compounds from oil, reducing air pollution associated with its use. Costs of
Econom ic Review

21

the technique are reported to range from $10 to $45
per additional barrel of oil recovered (Sidney J. Nelson
and Phillip D. Launt 1991). At the lower end of that
range, there is room for considerable profit, even at
current oil prices.
Additional Oil Sources. A potential, but costly,
new supply of oil could be obtained by applying existing technology to shale containing oil, of which the
United States has e n o r m o u s deposits. C o l o r a d o ' s
Piceance Basin alone contains more proved oil reserves in shale than exist in the Middle East (Ivan V.
Klumpar and Malcolm A. Weiss 1988). However, oil
recovery from shale has so far proved not to be economical, in spite of massive investments in developing
recovery processes. Nevertheless, as in the case of oil
in Alaska's National Wildlife Refuge, the potential of
this energy source may help limit current prices.

Table 3
Natural Gas Production
By Principal Country and Region
(percentage

1975

22



Econom ic Review

1985

1989

53.3

43.8

35.1

31.5

7.2

5.2

5.1

5.7

Mexico

1.7

2.2

2.1

1.8

44.3

36.4

28.0

24.0

2.5

2.9

3.3

3.1

22.0

27.5

36.1

38.4

3.8

4.8

4.6

4.0

12.8

13.1

10.8

9.1

6.8

5.0

4.6

3.5

NA

1.3

1.4

1.4

2.6

3.8

2.4

2.2

United States
South America
USSR
Other Communist

Netherlands

A number of energy forms may be substituted for
oil. Some are reasonable economic alternatives for
particular uses and in particular places even at current
oil prices. However, the cost structure—including
costs of pollution a b a t e m e n t — o f most substitutes
would require substantial hikes in oil prices from the
current level to make them competitive.
Natural Gas. As shown in Tables 3 and 4, natural
gas supplies are much more abundant in North America than are reserves of crude oil (see also Tables 1
and 2). In addition, because past exploration efforts
have tended to target oil, plentiful gas reserves probably remain to be discovered. Because gas is difficult to
contain, has high distribution costs, and is seldom
found near major areas of energy use, producers have
shunned or flared off any produced in conjunction
with oil. Although gas is not a good substitute for oil
in all uses, viewed from the standpoint of its total cost
in use as compared with other fuels, gas ranks second
to oil as an affordable energy source.
Recently, heightened concerns about atmospheric
pollution f r o m oil and coal c o m b u s t i o n have increased interest in gas as a clean-burning fuel for
electric power plants as well as for residential and
commercial heating and cooling. Decontrol of natural
gas prices in the United States in the late 1980s also
gave producers an incentive for increasing investment
in developing domestic natural gas resources. Exploration and production as well as construction of new
pipelines have all increased. Nevertheless, the major

1980

Canada

North America

Western Europe

.Energy Sources besides Oil

of world total)

Norway
United Kingdom

NA

1.6

2.7

3.0

Algeria

NA

0.9

2.1

2.2

M i d d l e East

Africa

3.8

2.2

2.7

4.9

Iran

3.2

0.5

0.6

1.1

Saudi Arabia

NA

0.5

0.3

1.5

1.7

4.1

4.6

6.0

Indonesia

0.4

1.8

1.4

1.8

Total W o r l d

46.9

55.7

62.9

73.4

Asia-Pacific

(Trillions of
c u b i c feet)

Source:

Energy Statistics

Source

Book (1990).

problem of delivering gas supplies from remote locations remains.
A technique for solving the problem of capture and
transport of the energy from gas is to build electricitygenerating facilities near gas wells. The variable costs
of transporting electricity by cable to consuming areas
would be more economical than transferring gas by
pipeline or pressurized container. However, for gas to
become a profitable and therefore feasible energy
source on a significant scale, extensive front-end costs
of building generating facilities would require higher
energy prices or technological advances that would
sharply reduce transmission costs.
November/December 1991

Table 4
Estimated Proved Natural Gas
By Principal Country and Region
fas of January

7, 7 990)

Reserves
(trillions of
cubic feet)

W o r l d Total

336.9

Canada

8.1

97.0

North America

2.3

72.7

United States

1.7

167.1

Mexico

4.0

163.6

Argentina

3.9

26.3

South America

0.6

105.7

2.5

1,564.9

37.5

Venezuela
Eastern Europe

1,550.0

37.1

203.6

USSR

4.9

Western Europe

1.5

60.9

Netherlands

2.2

93.1

Norway

0.5

19.8

United Kingdom

5.3

221.6

Africa

0.7

29.2

Libya

47.4

1.1

1,341.2

32.1

Nigeria
M i d d l e East

14.4

600.0

Iran

2.6

110.0

Iraq

48.6

1.2

162.0

Kuwait
Qatar

3.9
4.4

1 84.4

Saudi Arabia

184.4

Far East
Australia-New Zealand

4.4

345.7

United Arab Emirates

8.3

77.4

1.9

65.8

Brunei-Malaysia

1.6
0.8

33.0

China

0.5

20.9

India

85.7

2.1

23.0

0.6

4,177.2

100.0

Indonesia
Pakistan
Total W o r l d

Twentieth

2.7

114.2

Algeria

Source:

Percentage of

Century

Petroleum

Statistics

(1990).

Coal. Abundant coal reserves around the world also offer potential for electricity generation and for
heating. In cost of acquisition, coal is closely competi Bank of Atlanta
Federal Reserve


tive with oil. Based on the amount of energy supplied
to electricity-generating plants, coal is only half as expensive as petroleum and 60 percent as costly as natural gas. Furthermore, coal's prices have remained
relatively stable during the past decade, while oil and
gas prices were highly volatile.
However, impurities contained in coal pose major
pollution problems when coal is burned without precautionary treatments of the gases emitted. Further,
carbon emissions associated with coal combustion
have limited its use in most heating applications in the
United States. Electric power generation remains the
major stronghold of coal's current market, and that use
is increasing with the growth in demand for electricity.
Technology is available to clean up emissions from
coal combustion, but, again, the processes require considerable investment. To date in the United States
shipping clean-burning (low-sulphur) coal from its
predominant locations in the West to major user areas
in the East is less expensive than installing equipment
to rid high-sulphur eastern coal of its damaging impurities. Rising energy costs could at some point make
allocating resources to these treatments economically
justifiable, and coal would then become a significant
additional energy resource. Worldwide coal production is shown in Table 5.
Ethanol. Alcohol or ethanol distilled from various
plant starches has long been in practical use on a limited scale as an alternative to petroleum fuels in internal combustion engines. During the fuel crisis of
the 1970s investments allowed building plants to increase ethanol output, and ethanol was widely used
in the United States in a blend with gasoline as automobile fuel. In some countries with limited domestic
crude oil and foreign supplies, ethanol became the
primary motor fuel. In the United States, however,
subsidies were required to maintain ethanol output,
even from the most starch-rich plant sources. It is estimated that crude oil prices of S40 per barrel or more
would be required to make unsubsidized ethanol a
competitive fuel source (Sally Kane et al. 1989). Although current market conditions for gasoline suggest that c o m m e r c i a l p r o d u c t i o n of ethanol as a
substitute for gasoline is not imminent, the technology is available and continues to be refined through
ongoing research efforts.
Nuclear Power. Nuclear energy is already an important power source in Europe and the United States.
It has significant potential for supplying future energy
needs. Power from nuclear fission, a process that has
been especially adaptable to electricity generation, has
been in use for a number of years. Unfortunately, the
Econom ic Review

23

Table 5
Coal Production
By Principal Country and Region
(percentage

of world total)

1985

1988

1975

1980

18.8

21.0

17.9

19.9

18.2

18.2

USSR

21.1

18.9

16.5

16.5

Western Europe

21.3

19.8

18.9

17.6

13.9

12.6

11.9

10.6

3.9

3.4

2.1

2.2

12.3

11.8

10.9

11.0

3.5

3.3

2.9

2.7

6.4

6.1

5.7

6.0

North America
United States

Germany*
United Kingdom
Eastern Europe
Czechoslovakia
Poland

19.8

19.8

2.2

3.2

4.1

3.9

2.1

3.0

4.0

3.7

2.7

2.8

3.8

3.7

15.6

16.4

19.3

20.1

3.0

3.0

3.6

3,665

4,173

4,844

5,231

South Africa
Australia

India
Total W o r l d
(Millions of short tons)

* Includes

Source:

East

Germany.

Energy Statistics

Source

Book

(1990).

process also generates a number of costs that have restricted its development.
Fission plants produce vast quantities of waste heat
that can create environmental damage unless costly cooling devices are constructed. Nuclear power-generating
plants also produce tons of radioactive wastes annually;
these pose serious disposal problems. Further, accidental discharges of radioactivity can occur. Regulations
based on the knowledge and fear of such risks have
raised investment and operation costs of nuclear power
plants in the United States and Europe to such an extent
that d e v e l o p m e n t of nuclear power p r o g r a m s has
stopped. Further energy price increases, however, might
be sufficient inducement for power companies to invest
in nuclear programs again in the future.
Nuclear fusion is another potential form of nuclear
power generation. However, despite recent reports of

24


2

4.1

Africa

China

cold fusion, fusion's development is quite uncertain
and likely to be far in the future.
Hydropower. The use of hydropower, already widely used for generating electricity, could be expanded in
many areas of the world, but not enough to increase its
share of total energy. Hydropower is a cheap energy
source where natural water flows can be harnessed to
turn generating turbines. Even when lakes and reservoirs must be built to obtain water power, direct costs
are relatively low. However, costs associated with losing alternative uses for land and water, coupled with
destruction of natural habitat where dams are constructed, may make hydropower intolerably expensive
in many places. Furthermore, it is increasingly difficult to obtain approval to dam streams and form reservoirs for power generation. In many underdeveloped
countries, the overall costs of hydropower relative to
other sources of energy, including the capital investment required, prohibit expanding its availability.
In addition to the sources discussed above, solar
power, tidal actions of the oceans, and wind power
hold some potential for energy supply. At this point,
however, these and similar alternatives are either limited in projected output or await further development
of technologies capable of creating usable energy.

Econom ic Review

Conclusion
The world's current energy supply can be augmented in a number of ways, but these generally would create higher per unit costs and require investment of
resources and time. Nevertheless, the potential that
such alternative supplies represent probably serves to
limit current prices. A forecast that higher current
prices are likely to persist could induce investment in
new energy sources that would add to energy supplies
even if future prices fell.
A l t h o u g h petroleum is currently the d o m i n a n t
source of energy in use, possibilities exist for increasing the availability of a number of sources. However,
the supply of most of these substitutes, like the supply
of oil itself, will not respond to higher oil prices in the
short run. Little additional output can be produced immediately, even if oil prices increase sharply, leaving
consumers seriously vulnerable to short-term swings
in petroleum supplies (or quantities offered for sale).
Given time and additional investment, the quantities
supplied and the overall relationship between output
and price can adjust to changes in oil supply. Steps
could be taken to increase output from existing oil and
November/December 1991

the long run, the time it takes to convert existing facilities, to build new processing and generating plants,
and to perfect new technologies could result in substantial energy output expansions. Although the energy cost curve is steep at the outset of such ventures, it
flattens out as longer-run developments bear fruit,
even given current technology. Assuming continued
developmental research, breakthroughs, and applications of technology, it is likely that the cost curve
would even shift down as improved techniques resulted in the same output at lower costs.

gas wells and coal mines. New producing areas could
be opened up and alternative types of energy production
expanded. Various political restrictions on exploration
and production could be lifted. In addition to increasing
oil supply, efforts could go toward developing alternative sources like natural gas, coal, a l c o h o l f r o m
biomass, hydropower, nuclear power, and solar energy.
In most cases these alternatives would involve large initial investments.
If incentives are sufficient to set long-term developments in motion, there are likely to be rewards. Over

Notes
1. Proved reserves are the estimated quantities of crude oil that
geological and engineering data demonstrate with reasonable
certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions.

2. Electricity generation from fossil fuels is a more practical alternative under current price and cost structures.

Energy Statistics Source Book. 5th ed. Tulsa, Okla.: PennWell
Publishing Co.. October 1990.
Hunter, William C„ and Mary S. Rosenbaum. "Supply Shocks
and Household Demand for Motor Fuel." Federal Reserve
Bank of Atlanta Economic Review 76 (March/April 1991):

In Engineering Costs and Production Economics, 183-88.
Amsterdam: Elsevier Science Publishers, 1988.
Nelson, Sidney J., and Phillip D. Launt. "Stripper Well Production Increased with MEOR Treatment." Oil and Gas Journal 89, March 18,1991.
Hagar, Rick. "Placid Halts Ultradeepwater Project in Gulf." Oil
and Gas Journal 88, April 23, 1990, 30-31.
"Oil Field Chemicals Face a Shrinking Market." Chemicalweek
138. April 2, 1986.
Twentieth Century Petroleum Statistics. 46th ed. Dallas. Tx.:
De Golycr and MacNaughton, December 1990.

1-11.

Kane, Sally, John Reilley, Michael LeBlanc, and James
Hrubovcak. "Ethanol's Role: An Economic Assessment."
Agribusiness 5 (September 1989): 505-22.
Klumpar, Ivan V., and Malcolm A. Weiss. "Comparing Cost
Estimates of Processes at Different Stages of Development."

 Bank of Atlanta
Federal Reserve


Econom ic Review

25

eview Essay

Europe 1992:
An American Perspective
Edited by Gary Clyde Hufbauer.
Washington, D.C.: Brookings Institution, 1990.
406 pages. $25.00.

Janice L. Boucher

The reviewer is an assistant
professor in the Department of
Economics at the University of
South Carolina and a former
visiting scholar in the Atlanta
Fed's research department.
 26


Eco no m ic Review

n the mid-1980s many Europeans in business and government, worried about Europe's economic standing with respect to the United
States and Japan, began promoting a movement toward a more competitive, vigorous European economy. In July 1985 the European
Community (EC) formalized this vision of "Europe 1992" in the directives of a White Paper titled "Completing the Internal Market," which had at
its heart the goal of free (untaxed) movement of goods, services, capital, and
labor throughout Europe. These directives were validated in 1987 by the
Single European Act—an amendment to the 1957 Treaty of Rome—which
embraced the same fundamental economic objectives. A study released in
1988 heralded the net benefits the entire European C o m m u n i t y could
potentially reap by fully implementing the act's 282 directives. Since then
progress on the 1992 plan has continued, watched closely by those on both
sides of the Atlantic.
As the deadline nears for implementing Europe 1992, newspapers, trade
and academic journals, and books continue to report on the plan and to
opine about its expected effects in Europe and worldwide. Many analyses,
written mostly from a distinctively European perspective, have explored the
potential benefits and costs of the plan for Europe's peoples, businesses, and
governments. Some studies have looked specifically at the ways in which
reforms will affect the conduct of European business, on matters ranging
from hiring and taxation to mergers and acquisitions, from European governmental regulation and fiscal policy to industrial policy. Fewer analyses
deal with 1992's impact on U.S. businesses and how they can better prepare
for the coming European economic order.
It is generally expected that 1992 either will present the United States with
a large market where great business opportunities abound or will create a
"Fortress Europe," effectively closing out American business. Few resources
November/December 1991

provide detailed information about the effects of
changes in European laws and regulations, government
policy, the competitive climate, and the trading environment on industries in the United States and their
means of doing business in Europe.
Europe 1992: An American Perspective aims to fill
this gap but falls short of the mark. In fact, the book's
title to some extent belies its contents. The book is a collection of seven essays commissioned by the Brookings Institution from respected figures in fields such as
economics, finance, and law. It purports to examine
progress on the Europe 1992 agenda as it relates to
four U.S. industries—banking and services, automobiles, telecommunications, and semiconductors—and
to two aspects of U.S. trade policy, competition and
negotiating strategy. However, a substantial part of
each article is devoted to explaining the 1992 plan's
effect on European businesses and industry market
structure as well as on EC trade policy with respect to
the United States and Japan. The American perspective touted as the book's theme emerges only through
each contributor's warnings to American businesses
operating in or exporting to Europe about the obstacles—for example, reciprocity, EC public procurement
policies, standard setting, and local content and domestic origin rules—they may confront. The essays
offer no fully developed discussions of the importance
of these issues to American firms. Despite this shortcoming, the book contains historical background that
gives the reader insight into the factors that led to the
1992 plan and how the attitudes toward it have been
shaped.

Overview
Readers unfamiliar with the particulars of the Europe 1992 agenda will benefit from the first chapter's
overview of the plan. Gary Clyde Hufbauer, the book's
editor, traces the origins of the 1992 agenda to the
Treaty of Rome, signed in 1957 by the original six
founding members of the European Community, and
mentions the United States' encouragement of the plan
as a form of containment against the Soviet Union.
The 1992 plan presents an opportunity for American companies to locate in a market with strong growth
prospects, notes Hufbauer, the Marcus Wallenberg
Professor of International Financial Diplomacy at
Georgetown University. He points out that, with this
opportunity in mind, U.S. government policy might be
directed more toward securing a favorable business
Federal Reserve Bank of Atlanta



climate for U.S. multinational firms operating in the
EC than toward the interests of U.S. firms exporting to
Europe.
Some U.S. industries will need to take an activist
role, he contends, to maintain competitive strengths
and to ensure that the trade climate between the United States and the European Community remains open.
For example, the U.S. high-tech industry could find itself at a disadvantage up against a technologically
advanced European industry that is subsidized collectively by EC members or that is engaged in panEuropean strategic alliances promoted by the member
governments. The General Agreement on Tariffs and
Trade (GATT)—a post-World War II agreement among
industrialized (and, more recently, developing) countries that loosened international trade restrictions and
provides a mechanism for settling trade disputes—permits subsidies for research and development. In hightech businesses, separating out whether subsidies are
being used for research and development instead of
for production could be difficult. Not only might such
subsidies give the EC an advantage in terms of production, but, under GATT rules, U.S. high-tech firms
competing with EC consortia could find it difficult to
settle accusations of unfair trade.
Hufbauer's discussion of several issues that may
crop up in United States-European Community trade
negotiations—reciprocity, national quotas, local content and domestic origin rules, technical standards, and
public procurement—includes examples of how these
issues could potentially affect U.S. economic interests.
Probably the least well thought-out section of the
chapter touches on some of the broader challenges the
United States faces as a consequence of the 1992 program. In an increasingly global market U.S. firms
must face such issues as their loss in world ranking by
size and deciding what nationality multinational corporations will bear as foreign companies increasingly
take stakes in each other. Government officials will
face questions like how management of the U.S. economy might respond to successes or failures in Europe
and whether the United States will retain the role of
"custodian of the international system" or share it with
the EC or Japan.

/ndustry Case Studies
Four chapters concentrate on the four industries,
identified earlier, that may prove to be the most contentious in terms of negotiating trade policies between
Econom ic Review

27

the United States and the European Community. These
case studies describe what the European climate will
likely be for U.S. businesses operating or hoping to
operate there. The authors point out that U.S. fiijns
will need to consider the implications of competing
with businesses that may become stronger through
pan-European mergers and acquisitions or—in some
high-tech industries—strategic alliances (or consortia).
Differences between American and EC government
procurement policies, product standards, and regulations could also pose difficulties for U.S. companies.
Although the case studies' authors adequately describe
the business e n v i r o n m e n t e m e r g i n g f r o m E u r o p e
1992, they fail to suggest tactics that U.S. businesses
might want to pursue to compete in the European
Community.
For the short-term—until about 1994—the U.S.
banking industry will probably feel little impact at
home from the 1992 plan. Authors Carter H. Golembe
and David S. Holland predict that over the longer run,
however, competition with European banks will force
changes in U.S. regulations to allow consolidation of
banking and service-related industries. To compete
with the banking system in Europe 1992, the U.S. system of financial institution regulatory agencies may
push to reorganize its power structure.
The case studies of the automobile, telecommunications, and semiconductor industries—written, respectively, by Alasdair Smith and Anthony J. Venables;
Peter F. Cowhey; and Kenneth F l a m m — e m p h a s i z e
many of the same issues. The role the EC government
assumes in supporting European producers in these industries will critically affect American producers exporting to Europe. Although the Directorate General's
office, according to the 1992 plan, actively encourages
competition, these three industries may be coddled because they are considered "national champions" that
are key to Europe's competing effectively throughout
the world.
The argument for providing government support to
national champions, though contrary to the competitive spirit the 1992 plan seeks to achieve, was perhaps
most clearly brought home to the EC by its experience
in the semiconductor industry during the 1960s. European computer markets remained protected from U.S.
and Japanese competition during this time and emphasized meeting the needs of local rather than foreign
computer manufacturers. The EC failed, for a number
of reasons, to establish itself as a producer in the global semiconductor market and instead was largely a
consumer. Europe had fallen behind the United States
and Japan in c o m p u t e r t e c h n o l o g y and t h e r e f o r e
 28


Eco no m ic Review

missed cashing in on the explosive growth of the computer industry. The European industry could not keep
pace in production or in the user markets.
Events like these have shaped the EC's attitudes toward the industries it foresees will be crucial to remaining competitive in world markets, and these
nationalistic biases cannot be easily dispelled. Moreover, EC policymakers have yet to draw the line between the advantages of unfettered competition and
protection in industries whose prosperity tends to spill
over to other industries.
U.S. firms must participate in EC standard setting
in each of these industries, the case studies' authors
caution, or find themselves denied access to European
markets because their products do not meet EC standards. In the chapter on the semiconductor industry,
Flamm suggests that international standards be negotiated through a GATT-like body to avoid development
of standards that will favor EC-produced goods.
Testing and certification standards must also be negotiated, these authors believe. U.S. goods that meet
international production standards could still be denied entry into EC countries if their testing and certification results do not meet EC specifications. In the
automobile industry, for example, the EC did not
adopt the same testing and certification procedures as
the United States. As a result, U.S. auto exports could
be blocked on grounds of failure to pass European
testing and certification even though they may meet
manufacturing standards. Of course, European auto
producers' exports to the United States could also
meet the same obstacle. Smith and Venables neglect to
mention that mutual self-interest may help deter such
an outcome.
The case studies' authors also discuss the potential
complexity of trade disputes that will emerge in a
global business environment. How will a decision be
m a d e , for e x a m p l e , as to whether the exports of
Japanese plants that operate in the United States will
be treated as Japanese or U.S. exports? Will U.S. automobiles produced and sold in Europe be treated as European or American goods? Resolution of such issues
might not be forthcoming until trade negotiations
specify plans for these industries.
The essay on telecommunications, although the
most technical, provides the most in-depth discussion
of the potential effects of Europe 1992 on U.S. businesses and trade policies. Cowhey contends that, to
compete globally, U.S. telecommunications firms must
pursue new ways of combining services and equipment into products that satisfy market demands in innovative ways. This goal may best be accomplished by
November/December 1991

small and medium-sized firms and could be further
promoted by changing regulations in the U.S. telecommunications industry.
Another concern in this industry is that public procurement procedures within the EC may hurt U.S.
firms. Although the EC has adopted more transparent
public procurement rules, the United States is concerned that these will not be extended to the largest
purchasers of telecommunications products like the finance, defense, and transportation ministries. In such
an event, U.S. telecommunications exporters would
lose an important market segment and any potential
clients that might have been exposed to the product
through these avenues.

Competition Policy and
Negotiating Strategy
The chapter on competition policy examines an important question about the 1992 program: if the goals
of a more competitive economic environment and improved consumer welfare are in conflict, how will the
conflict be resolved? Competitive policy, in some instances, may be superseded in the interests of national
security, consumer safety, or environmental protection
by means of trade barriers to non-EC goods and services. The author of this chapter, Douglas Rosenthal,
does not consider cases in which stricter health, safety,
or environmental standards could have the paradoxical
effect of encouraging companies to shift production to
countries outside the EC with slacker standards.
Rosenthal, a partner in the Washington office of the
international law firm Coudert Brothers and a former
chief of the Foreign Commerce Section of the Justice
Department's Antitrust Division, examines various aspects of competition policy as it relates to intra-EC
business activity and U.S.-EC business and trade relations from a legal standpoint. He assumes that the reader has a fairly broad familiarity with technical law
terms and the EC's governmental branches and their
roles in policy-making. Five features of the 1992 program are examined: deregulation, market restructuring,
antitrust enforcement, industrial policy, and external
trade policy. The author concludes that European competition and trade policy will not create a "Fortress Europe" because it is not in the EC's interest, although he
notes some caveats to this claim. For example, a recession in Europe or conflicting trade and industrial policy
goals of the m e m b e r states may interfere with the
progress and resolve to completing the internal market.
Federal Reserve Bank of Atlanta



Five aspects of European competition policy will
be most influential in European Community-United
States relations, in Rosenthal's view. These issues are
(1) the timing for and extent of removal of government barriers that impede the "four freedoms"—the
free mobility of goods, services, capital, and labor; (2)
the degree of market access permitted, especially by
merger or strategic alliance, based on the principles of
national treatment and nondiscrimination; (3) the extent to which outside firms, including U.S. firms, are
targeted for private restraints perpetuated by European
firms; (4) the degree to which competition is disturbed
by EC institutions' or member states' providing subsidies to favored firms or consortia to make them "more
competitive" or to give them "short-term relief' from
market setbacks; and (5) the question of whether foreign firms can obtain equal access by exporting to European markets.
An important detail Rosenthal highlights is that the
channels through and process by which U.S. firms are
accustomed to having legal disputes resolved are
somewhat different in the EC. In the United States private firms bring antitrust complaints to the attention of
the U.S. court system. In the EC the European Commission initiates most antitrust suits.
Another noteworthy point he makes is that the EC's
antitrust legislation—and, in fact, much of its competition policy—is "being shaped in the dark" because the
rules and cases are new and few precedents have been
established. Pursuing and maintaining some of the key
directives of the 1992 plan could be hampered because
the Directorate-General Offices responsible for ensuring that the plan's competition policy is carried out are
not sufficiently staffed to monitor and investigate it.
This lack of staffing could also prove a hindrance to
any U.S. businesses that bring charges of unfair play
before the EC Commission.
In a brief examination of external trade policy in
the United States and the European Community since
the late 1980s, Rosenthal points out that there is a
"separation of the spheres of influence" of antitrust
and trade policy in both the United States and the EC.
He advises that the United States monitor the degree
to which trade policy's effects on competition are considered in shaping the EC's domestic competitive policy. This theme, whether explicit or not, runs through
all of the essays.
The chapter on negotiating strategy, written by
Joseph Greenwald, an attorney and former U.S. Ambassador to the European Economic Communities,
emphasizes that the United States must seek other
channels—in addition to the Uruguay Round of the
Econom ic Review

29

GATT talks—for negotiating trade policy with the European Community. Given its new economic status as
a rival of the United States, the EC has become and
will likely continue to be more contentious in trade
disputes, Greenwald notes. The current dispute between the United States and the EC over agricultural
policy is an example of how problems in one area
could spill over into other areas of negotiation.
The author's discussion of general negotiating strategy issues is lesS well articulated than the other sections of the chapter. Outlining three approaches to
negotiating strategy—a global approach using the
GATT framework; a national approach pursuing priority issues case by case, possibly through bilateral
agreements; and a regional approach establishing an
exclusive U.S.-EC deal—Greenwald notes that these
approaches may overlap but offers no insight as to
which might be the most prudent to use or why.
The chapter discusses three specific trade issues between the United States and the EC: services, standards,
and testing and certification. Services, the author suggests, should be included as part of a separate agenda
of the GATT talks and perhaps even pursued bilaterally. The United States should monitor standards and
testing and certification requirements to ensure that
they do not become technical barriers to trade.
Government procurement policies, rules of origin,
quotas, and antidumping legislation as they are being
shaped in the EC are also discussed in this chapter.

 30


Eco no m ic Review

Greenwald closes with some recommendations for
strategies the United States may employ in negotiating
with the EC and suggestions for some organizational
changes in regard to the initiation of U.S.-EC trade
policy at the grass roots level.

Conclusion
Europe 1992: An American Perspective provides
particulars of the Europe 1992 agenda and highlights
some of the industries on which the plan is expected to
have a major impact as well as policy initiatives and
current or potential trade concerns. However, readers
may find only a few chapters to be of interest, especially given that the industry case study articles are
rather technical. The case studies merely touch on
general issues such as standard setting, public procurement, mergers and acquisitions, and trade policy and
consider the obstacles these matters may pose to
American companies doing business in Europe post1992. The book ultimately is disappointing because it
lacks in-depth discussions about carving market niches and exploiting already established market presence,
as well as practical suggestions for U.S. businesses
preparing for and dealing in a new economic environment. In short, the book is not a "how-to" manual.
Perhaps one is sorely needed.

November/December 1991

/ndex for 1991
Agriculture

Energy

Sullivan, Gene D„ "The 1990 Farm
Bill," January/February, 22

Hunter, William C., and Mary S.
Rosenbaum, "Supply Shocks and
Household Demand for Motor
Fuel," March/April, 1
Sullivan, Gene D., "Prospects for
Energy Supplies," November/
December, 17

.Banking
Goudreau, Robert E., and B. Frank
King, "Commercial Bank Profitability: Hampered Again by
Large Banks' Loan Problems,"
July/August, 39
Hunter, William C., and Stephen G.
Timme, "Some Evidence on the
Impact of Quasi-Fixed Inputs on
Bank Scale Economy Estimates,"
May/June, 12
King, B. Frank, "Review Essay:
Manias, Panics, and Crashes: A
History of Financial Crises, by
Charles P. Kindleberger,"
January/February, 30
Srinivasan, Aruna, "Review Essay:
The Interstate Banking Revolution:
Benefits, Risks, and Tradeoffs for
Bankers and Consumers, by Peter
S. Rose," March/April, 42
Tallman, Ellis W., "Review Essay:
The House of Morgan: An American Banking Dynasty and the Rise
of Modern Finance, by Ron Chernow," September/October, 28

.Defense Spending
Whitehead, David D., "The Impact
of Private-Sector Defense Cuts on
Regions of the United States,"
March/April, 30
Federal Reserve
 Bank of Atlanta


Financial Markets
Abken, Peter A., "Beyond Plain
Vanilla: A Taxonomy of Swaps,"
March/April, 12
Abken, Peter A., "Globalization of
Stock, Futures, and Options Markets," July/August, 1
Cohen, Hugh, "Evaluating Embedded Options," November/December^
Smith, Stephen D., "Analyzing Risk
and Return for Mortgage-Backed
Securities," January/February, 2
Stowe, David W „ "The Interest Rate
Sensitivity of Stock Prices,"
May/June, 21
Wall, Larry D., "Recourse Risk in Asset Sales," September/October, 1

international Trade
and Finance
Boucher, Janice L., "Europe 1992: A
Closer Look," July/August, 23
Boucher, Janice L., "Review Essay:
Europe ¡992: An American Perspective, edited by Gary Clyde Hufbauer," November/December, 26

Chriszt, Michael J., "European Monetary Union: How Close Is It?"
September/October, 21
Donovan, Jerry J., "Review Essay:
International Trade and Finance
Information Sources: A Guide
to Periodical Literature," July/
August, 55
Donovan, Jerry J., "Review Essay:
International Trade and Finance
Reference Sources," May/June, 30
Tallman, Ellis W„ and Jeffrey A.
Rosensweig, "Investigating U.S.
Government and Trade Deficits,"
May/June, 1

Macroeconomic Policy
Cunningham, Thomas J., "A Liberal
Discussion of Financial Liberalization," November/December, 1
Espinosa, Marco, "Are All Monetary
Policy Instruments Created
Equal?" September/October, 14
Tallman, Ellis W., and Jeffrey A.
Rosensweig, "Investigating U.S.
Government and Trade Deficits,"
May/June, 1

Migration
Kahley, William J., "Population Migration in the United States: A
Survey of Research," January/
February, 12

Econom ic Review

31







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