Latin American Capital Markets

344 A. M. CORCORAN, R B. HOBSON, G.J. KUSERK, K. K.WUERTZ,AND QWESTcan also serve as a viable base for derivatives contracts. Corporate debt tends to varywidely in terms of the credit risks of the issuers, the term structure of the instruments,and the regularity with which debt is issued. As such, corporate debt is often a less attractivecandidate in its raw form for establishing liquid markets in standardized derivativescontracts. In addition, thin supplies of corporate debt often characterize LatinAmerican markets, as companies tend to raise funds through bank borrowing ratherthan issuing debt securities.There are two approaches for dealing with the limited supply and heterogeneousnature of corporate debt (or other similar products).The first approach, whichinvolves a cash market solution, is to pool or convert heterogeneous debt into homogeneousdebtThrough securitization, assets having similar attributes can be pooledinto vehicles on which new securities are issued. In this way, small supplies of somewhathomogeneous assets can be pooled together to create a larger supply of assets.Similarly, quite different assets can be pooled together to create similar instruments.In this case, pooling and securitization transcend diversification in the pool of assetsto create homogeneous securities out of heterogeneous ones. Government or privateguarantees attached to securitized instruments can further enhance the homogeneityof the instruments. 8The second approach to dealing with a heterogeneous class of financial assetsis to tailor an OTC product precisely to the expected risk management use. Butthis chapter focuses on the exchange solution. A hybrid solution would be to establishan auction for more tailored solutions.This approach typically involves the creationof customized OTC derivatives contracts, where the derivatives contract can be tailoredto reflect the idiosyncrasies of the underlying instrument The advantage of thisapproach is that basis risk can be reduced to very low levels.The downside, howeveris that liquidity risk rises as customers in this market are reliant on the derivatives contractissuer to make a market in the instrument. A possible third option would be toorganize an automated bidding process seeking bids from several offerers to price aspecific OTC risk management solution.Characteristics of the Underlying MarketThree characteristics typically are of importance in assessing the suitability of the underlyingmarkets: price volatility, market size, and participatory structure. Above allCopyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub8 For example, mortgage-backed securities issued by U.S. government-sponsored entities have to date been less successfulthan government bond contracts.