Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 339As the discussion proceeds, it will become clear that developed (and developing)capital markets can facilitate the establishment of derivatives markets of alltypes. In fact, the relationship between derivatives markets and capital markets is symbiotic.By providing a means of managing the risks associated with capital (and commodity)market transactions, derivatives markets complement and improve overallmarket structure in that they can do the following:• Support market-making activities• Render the underlying financial and other markets more accessible and hencepotentially more efficient• Reduce volatility in the pricing of commodities or financial instruments• Promote better management of production and procurement by permittingrisk shifting and facilitating price discovery• Provide incentives for centralizing delivery facilities and grading and standardizingproducts• Reduce the cost of financing commercial transactions.For example, in Mexico, as an alternative to long-standing policies that guaranteedminimum prices, the government began to offer farmers and their associations theopportunity to purchase price insurance. Although the program was launched as away of reducing farmers' income risk, improved credit access was an unanticipatedbenefit because banks apparently were more willing to lend to program participants(World Bank and IMF 2001). Mexico has tried several times to establish a futures marketin financial instruments and is optimistic that its current initiatives in that regardwill be successful.Market users and the economy as a whole can benefit from properly overseennoncommercial speculative activity that is essential to the functioning of exchange-tradedderivatives markets. Beyond providing market users with valued liquidity,which in turn complements market price discovery, such speculative activitycan contribute to greater price stability in the markets underlying the derivatives bypermitting hedgers to lock in favorable prices and by rendering the price more transparentand efficient. A market purely of commercials, which are entirely involved intrading for their own business-related interests, may not obtain the same results becausecommercials may have narrow interests that may not produce sufficient tradingfor an efficient price. Furthermore, as demonstrated by some of the alleged activity inthe California cash energy markets, protection against manipulative activities is essentialfor proper price formation.That being said, because the price discovery and risk-Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub