Fiscal shocks and fiscal risk management

We use the returns on a set of international financial securities to identi fy exogenous shocks to the Canadian federal surplus. We find that a large p ortion of the variation in the surplus can be replicated by a linear combin ation of these returns and that the recent rise in debt resulted from adver se shocks and a delayed response by the government. We develop a framework to evaluate the gains from a risk management strategy, using these securiti es to hedge against shocks. We find that hedging generates significant welf are gains by enhancing the sustainability of fiscal policy and diversifying the risk associated with tax changes. (C) 2001 Published by Elsevier Scien ce B.V.