Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 365risk and concomitant credit risk is the same exercise in OTC markets, but is more difficultin that the prices for esoteric instruments, or long-dated instruments, may bemore difficult to derive in the absence of disseminated prices and in light of the complexityof such instruments. Quotations may be less useful as a measure of risk becauseof the need to negotiate reversals of transactions with the original counterparty,possibly after a change in circumstances.Portfolio systems for measuring appropriate margin, based on the overall riskof a combination of futures and options positions, are used globally by many futuresmarkets. 41 However, these systems can be vulnerable to dramatic change based onchanges in volatility.This is because not only are projections of market risk uncertain,but also implied volatility can only be estimated. In addition, options prices are unstableas they move toward expiration or where their intrinsic value is deep out of themoney.Therefore, regulatory and market authorities, as well as policymakers, shouldensure that margin is complemented by other risk management measures.Credit Risk and Clearing Member RequirementsCredit risk is the risk of counterparty default. Because exchange markets are symmetric,market and credit risk are related and exist irrespective of the direction inwhich the price is moving. 42 As a consequence, two-way collateral usually is required,that is, both counterparties to each transaction are required to post margin. 43 Suchmargin is considered, and commonly called, a performance bond because it guaranteeseach counterparty's commitment to make daily settlement to the clearing organizationof any losses resulting from price movements.On many futures exchange markets, the clearing organization substitutes itscredit for that of individual counterparties and manages the accumulation of risk bythe daily or more frequent payment and collection of variation margin on each futuresposition.The clearing organization usually uses a one-day measure of market risk41 The Standard Portfolio Analysis of Risk Margining (SPAN) system, approved by the Commission for use at theChicago Mercantile Exchange on November 21,1988, is a proprietary model based on Black Scholes used by all futuresmarkets in the United States. Many other markets have adopted this model, although the markets can specifyparameters unique to conditions in their case. Interestingly, the SPAN system produces substantially similar results tothe Theoretical Intermarket Margining System, the Cox-Rubinstein model employed by the Chicago Board OptionsExchange, and the Options Clearing Corporation. The U.S. Securities Exchange Commission first approved this systemon a pilot basis for setting certain capital charges. See Securities and Exchange Act Release No. 34-33761 (59Fed. Reg. 13275, March 21, 1994).42 Acknowledging this relationship is fundamental to the design of credit support facilities for futures markets.43 In Brazil, certain counterparty contracts that are settled and guaranteed by the BM&F are supported by two-wayexchange collateral requirements.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub