Latin American Capital Markets

364 A. M. CORCORAN, R. B. HOBSON, G. I. KUSERK, K. K. WUERTZ,AND QWESTRisk ManagementAn essential component of futures regulation and derivatives market functionality is toensure that the credit enhancement mechanism permits financially sound, anonymousconclusion of derivatives transactions and limits excessive speculation. Anonymoustransacting requires reliable credit enhancement and clearing mechanisms.There areseveral models for these, but most active derivatives markets use central counterpartyclearing.The basic risk management features that require regulatory or statutorysupport are described here. 39Market Risk and MarginMargin is the stake in a transaction and security against its completion. As such, marginis viewed as essential to exchange markets, but may be insufficient to address marketrisk for a number of reasons. Margin is backward looking. It is calculated using variablesthat are estimates or projections. In addition, margins must be set at levels thatpermit economic use of the market for hedging purposes.Therefore, it is unlikely thatmargin would, could, or ever should cover all outlier price moves.There must be noquestion that, absent collusion, margin can be used as good collateral; in many cases,building such confidence will require both a fair governance framework and speciallegislation. 40 The appropriateness of margin and access to margin by the credit facility(brokers and the clearinghouse) must be indisputable as a matter of law and as amatter of fact.On most U.S. futures markets, for example, performance bond margin (thatis, standing maintenance or clearing margin) is only intended to cover at least 95 percentof historical observations (of specified durations) of one-day price moves. Inpractice, most exchanges look at six months, three months, and one month of pricedata, as well as five- and 10-year data, current events, and implied option volatilitiesin setting margin levels. For example, the price moves in U.S. markets on October 19,1987, October 20, 1987, or October 13, 1989, exceeded standing margin many times.That being said, changes in price equivalent to the current margin requirement haveoccurred on only a small percentage of days since October 1987. Projecting market39 Portions of this section have been adapted with permission from Corcoran (1994).40 For example, formerly in Germany, margin posted on futures contracts was not collectable because the contractspotentially violated wagering laws. In the United States, there are special bankruptcy provisions that provide that paymentof margin is not a preferential transfer (see Sec. 548 [d] of Title 11 of the U.S. Code). The Settlement FinalityDirective in the European Union accomplishes the same objectives.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub