Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 343Table 11-21 Trade-off between Futures and ForwardsI or Exchange and OTC Designs GenerallyCharacteristicCounterpart credit riskContract termsDelivery expectedTiming flexibilityRegulationLiquidity requirementsCapital requirementsForwardsHighFlexibleYesNoLowLowHighFuturesLowInflexibleNoYesHighHighLowcontrol of the developer In terms of selecting the potential financial assets on whichto develop highly standardized and liquid contracts, those assets that are homogeneousand freely available in large quantities serve as the best candidates. This hasbeen clearly observed in the history of agricultural markets, where the most successfulfutures and options markets have been for widely available, highly standardizedcommodities such as corn, soybeans, coffee, and sugar 7Homogeneity and Contract DesignAs with agricultural markets, homogeneity in financial assets often plays an importantrole in the success of a derivatives contract. Capital market assets are essentially definedby the credit risk of the issuer, or assets backing the issue, and the term structureof the individual issues.The similarity of credit risks and term structures of individualissues within a class define the homogeneity of a particular class of instruments.For example, in comparing national government-issued debt versus corporate debtwithin a particular country, the government debt tends to be more homogeneousthan the corporate debt in terms of credit risk because the issuer is constant acrossthe debt. In addition, governments often issue debt at regular intervals and of similarmaturities, which leads to homogeneity in term structure.While national government debt typically represents the largest pool of homogeneouscapital market assets in an economy, and is the most likely candidate as areference price for financial derivatives, corporate debt, although less homogeneous,7 For example, the attempt to establish cattle futures markets in some Latin American jurisdictions has experienceddifficulty because they do not use feedlots for developing a sufficiently standardized product to permit reliable deliveryand pricing.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub