Fiscal shocks and fiscal risk management

We use the returns on a set of international financial securities to identify exogenous shocks to the Canadian federal surplus. We find that a large portion of the variation in the surplus can be replicated by a linear combination of these returns and that the recent rise in debt resulted from adverse shocks and a delayed response by the government. We develop a framework to evaluate the gains from a risk management strategy, using these securities to hedge against shocks. We find that hedging generates significant welfare gains by enhancing the sustainability of fiscal policy and diversifying the risk associated with tax changes. (C) 2001 Published by Elsevier Science B.V.