Latin American Capital Markets

348 A. M. CORCORAN, R. B. HOBSON, G.J. KUSERK, K. K. WUERTZ,AND QWESTCommercial TermsBecause of the critical role that commercial participation plays in the ultimate viabilityof a derivatives contract, an overriding consideration in the design of such contractsis the incorporation of terms and conditions that reflect commercial cash marketpractices.This is generally not a challenge in the case of a bilateral, counterpartycontract. Where such contracts are individually negotiated between two parties, onlythe business practices of the contracting counterparties need be considered. For acontract that is to be standardized and widely traded, however; there likely exists arange of practices that may be specified.The choice of these may be relevant not onlyto assuring the success of the contract, but also to preventing manipulation and ensuringprice convergence at expiration.It is, in fact, the quest for standardization that gives rise to the trade-off betweenpricing specificity and deliverable supply in designing exchange-listed derivativescontracts. One way of addressing this problem is to design a contract that permitsdelivery of a range or "basket" of issues and maturities that at the same timeprovides for price adjustments (or a formula that calculates such adjustments) that reflectcash market valuation differentials. 14 The key to this approach is the specificationof futures price delivery adjustments that are responsive to changes in cash marketfundamentals.This has proved to be difficult in the context of agricultural futures markets,but less so for financial futures and options.An alternative way of addressing the pricing/supply issue is to incorporate acash settlement feature into the contract in lieu of a physical delivery requirement.This, of course, eliminates any deliverable supply and convergence concerns andallows the contract designer to be more specific regarding the asset to be pricedvia the derivatives contract. However, cash settlement raises considerations similar tothose surrounding delivery, owing to the need for a reliable cash market referenceprice on which to base the settlement price. In addition to the timeliness and publicavailability of the pricing information used to calculate the reference price, a viablecash settlement procedure presupposes a liquid cash market with a low potential forprice manipulation or distortion or other controls to ensure the integrity of pricing.The pricing methodology should be transparent, with clear criteria for its calculation.These steps should prevent tampering or leaking material information to market participantinsiders (Tokyo Communique 1997; IOSCO 1998).Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub14 The Chicago Board of Trade bond contract is based on a basket with the convention that in the event of deliverythe "cheapest to deliver" issue will be the deliverable.