Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 345other characteristics, price volatility is the most important prerequisite for a commodityor asset market for which a complementary derivatives market is being developed.Volatility creates a demand for risk management that is translatable into demandfor effective derivatives contracts and, thereby, supports liquidity in a market forsuch contracts. This in turn renders the market an effective venue for risk transferPrice volatility by its nature creates a commercial risk for those investing in and issuingcapital market instruments.Thus, to the extent that price volatility is high, there willbe a greater need to hedge price risk and therefore to use risk transfer instruments.At the same time, price volatility generates speculative activity that in turn creates risktransfers for commercial users that seek to use derivatives contracts to render theirown price risk less volatile, thereby permitting better management of their businesses.In essence, price volatility is the engine that drives derivatives markets. 9 Where volatilityis low, other means of managing risk may be available or the attendant transactioncosts will not warrant risk management activity.Price support programs that have been implemented for many physical commoditiesaround the world (for example, agricultural products) can affect the designand viability of derivatives contracts based on those commodities. To the extent theprice support program obviates producers' price risk, a derivatives contract to managethat price risk is not necessary and likely would be unviable if proposed by a marketoperator However, even in the case of a commodity covered by a price supportsystem, a derivatives contract designed to meet the needs of processors and users ofthat commodity may nonetheless be viable if the price risks of these traders are notaddressed by the price support system. In complex markets, such as the petroleummarket, where a group of producers forms an imperfect cartel that attempts to manipulatethe supply of the commodity the price volatility that results both from the cartel'smanipulation of the supply and the limitations on its ability to control the supplyis sufficient to support an active derivatives market. Furthermore, the market transparencythat is achieved through the operation of the derivatives market is used byboth cartel and noncartel members in making decisions concerning their operations.The overall size of the cash market is also an important consideration in assessingthe potential viability of a derivatives contract. When assessing the size of amarket, two characteristics should be considered: the outstanding supply of the financialasset and the volume or turnover in the market. Ideally, derivatives contractsshould be based on an asset that is issued in large quantities and actively traded in aCopyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub9 For example, in the United States, no financial or foreign exchange products were traded until the domestic deregulationof interest and exchange rates (Rudder Associates 2000).