Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 347ply of assets ensures that ample supplies of the assets are available when delivery obligationson derivatives contracts must be metThe same adverse effects can originateon the demand as on the supply side of the equation. That is, periodic episodes ofhigh demand could tie up the supply of the assets, and investors could try to lock upavailable deliverable supplies, thereby effectively reducing the overall supply of the settlementinstrument. 12 Thus, in choosing assets on which to base derivatives contracts,the best candidates are those assets with predictable patterns of issuance and demand,and where the source of supply is not subject to manipulation. If marketdevelopers are able to demonstrate a successful pricing track record, this shouldincrease interest in a market and result in enhanced liquidity.PotentialA/ternot/Ve Hedging or Risk Management Too/sThe decision to base a derivatives contract on a given commodity or asset must bebased on the demand for and supply of such contracts. Examining the cash marketfor the attributes (volatility, size, homogeneity, and structure) is akin to assessing thepotential demand for the contract.The companion question that also must be askedis whether other mechanisms exist that can satisfy that demand. 13 The early historyof financial futures and options market development in the United States suggests thatattempts to duplicate or even improve on existing active derivatives markets, includingnonindigenous markets that reflect the world price for a product, are doomed tofailure.The attempted development of a cattle futures market in Argentina providesan excellent example of the case in point: an existing forward pricing system, throughproviding risk exposure protection and merchandising opportunities, satisfied the hedgingneeds of the cattle industry and remained viable as a contemporaneous futuresexperiment failed. Technology may permit development of average pricing for cashmarkets, which also could undercut the need to develop more formal risk managementto smooth pricing for users and producers. With experience, derivatives exchangeshave focused on the development of unique contracts based on assets thatcannot be hedged otherwise.12 For example, Fenchurch attempted to corner the supply of 10-year treasury notes through the repo market, thusforcing the shorts to deliver more valuable treasury notes and thereby increasing the costs of delivery pursuant tothe conventions of the Board of Trade contract (CFTC 1996). Under those contracts, which represent a basket ofsecurities, several notes would qualify as deliverable. Use of the product, however; is based on the expectation thatshorts will deliver the "cheapest to deliver" at the end of the delivery period.13 Common impediments to derivatives market development are the inability to develop speculative (intermediary)interest, objections from the cash market the fear of cash market participants that the product will exacerbate ratherthan moderate volatility, and alternative venues or means of risk managementCopyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub