A Survey of Emerging Derivatives Markets

Donald Lien and Mei Zhang

ABSTRACT: This paper summarizes theoretical and empirical research on the roles and
functions of emerging derivatives markets and the resulting implications on policy and
regulations. Previous studies revealed that commodity derivatives markets offered an ef-
fective and welfare-improving method to deal with price volatility. Financial derivatives
markets have helped to support capital inflows into emerging market economies. On the
other hand, the use of financial derivatives has led to exacerbated volatility and accelerated
capital outflow. There is a consensus that derivatives are seldom the cause of a financial
crisis but they could amplify the negative effects of the crisis and accelerate contagion.
Previous studies of derivatives markets have supported the hedging role of emerging deriva-
tives markets. Empirical results from a few emerging countries suggest a price discovery
function of emerging futures markets. The findings on the price stabilization function of
emerging derivatives markets are mixed. Finally, recent research has documented that
constructive development of derivatives markets in emerging market economies needs to
be supported by sound macroeconomic fundamentals as well as updated financial policies
and regulations.
KEY WORDS: commodity derivatives, emerging markets, financial derivatives, hedging,
price discovery, price stabilization.

Derivatives markets contribute to the development of the financial infrastructure of a

country by making links among cash markets, hedgers, and speculators. Local deriva-
tives markets have grown rapidly over the 1990s in emerging economies, especially in
large emerging economies that have removed capital controls and developed their own
underlying securities markets. The increasing use of derivatives products offer alterna-
tives for efficient risk management, facilitate capital flows into emerging economies, and
create conditions for raising system risk and magnifying negative effects during episodes
of financial crisis. These developments raise a number of intriguing questions. What are
the roles of derivatives markets in emerging market economies? What is the relationship
between derivatives markets and financial crises in emerging market economies? How do
the emerging derivatives markets function compared to their counterparts in developed
economies? What lessons are learned from the development process of emerging deriva-
tives markets in the past decade? What are the policy and regulatory implications? In these
contexts, emerging derivatives markets have been the focus of much academic scrutiny.
This paper summarizes current theoretical and empirical research on the roles and
functions of emerging derivatives markets and the resultant policy and regulations im-
plications. We follow the research line of earlier surveys that examined various aspects

Donald Lien (don.lien@utsa.edu) is the Richard S. Liu Distinguished Chair in Business at the
University of Texas–San Antonio. Mei Zhang (zhangm@shfc.edu.cn) is a lecturer in finance at
Shanghai Finance University. Part of this work was completed when the first author was visiting
Shanghai Finance University. The authors acknowledge the editor, Ali Kutan, for continuous sup-
port and encouragement, James Groff for helpful comments and suggestions, and Beth Guajardo
for excellent editorial assistance. Nonetheless, the authors are solely responsible for all omissions
and commissions.

Emerging Markets Finance & Trade / March–April 2008, Vol. 44, No. 2, pp. 39–69.
Copyright © 2008 M.E. Sharpe, Inc. All rights reserved.
1540-496X/2008 $9.50 + 0.00.
DOI 10.2753/REE1540-496X440203
40 Emerging Markets Finance & Trade

of the roles and functions of emerging derivatives markets. The International Monetary
Fund (IMF 2002) reported the size of emerging derivatives markets and their effects on
recent financial crises. Morgan (2001) examined policy attempts to reduce the effects
of price volatility on primary commodity markets. Dornbusch et al. (2000) provided an
excellent review of the studies exploring the exact causes of volatility in international
capital flows. Flood and Marion (1999) surveyed studies of the causes and consequences
of financial crisis. Lien and Tse (2002) surveyed recent developments in optimal hedging
strategies. Mayhew (2000) reviewed the literature on price discovery and price stabili-
zation functions of derivatives markets, and Bekaert and Harvey (2003) reviewed the
literature on contagion in the context of emerging market finance.

Overview
Commodity futures markets have long been known to provide risk reduction instruments
and disseminators of price information, functioning as a forum for the activities of both
hedgers and speculators. Commodity futures markets have expanded mostly in developed
economies, though the establishment and use of commodity futures markets in emerging
market economies has gained increasing importance in recent years as a possible solu-
tion to the price and revenue volatility problems faced by commodity producers. Among
emerging economies, the Korean Stock Exchange and Bolsa de Mercadorias & Futuros
of Sao Paulo (BM&F) in Brazil ranked among the largest exchange-traded derivatives
markets in the world in the number of contracts traded by the end of 2001 (IMF 2002).
In the late 1980s and early 1990s, markets for financial derivatives were initiated in
Hong Kong, Japan, Brazil, and most of Western Europe. In the latter half of the 1990s,
more emerging economies began trading index futures and other financial derivatives.
In many emerging market economies, long-term plans are underway to introduce deriva-
tives exchanges. The December 2002 issue of the IMF Global Financial Stability Report
(IMF 2002) surveyed the emerging financial derivatives markets, covering markets for
currency, fixed income, equity-linked, and credit derivatives. Generally, local financial
derivatives markets in emerging market economies differ greatly in their sizes, both in
absolute terms and relative to cash markets. Hong Kong SAR, Singapore, and South
Africa have the most liquid over-the-counter (OTC) currency derivatives markets among
emerging market economies, whereas the organized exchange BM&F holds a significant
share of foreign exchange derivative trading in Brazil. As of the end of June 2001, notional
amounts outstanding of foreign exchange derivatives totaled $370 billion in emerging
markets, against notional amounts of $20.5 trillion in global markets.
The most deep and liquid fixed income derivatives markets are in Singapore, Brazil,
and South Africa. The Singapore Exchange is by far the largest exchange in emerging
markets in the outstanding notional amounts of exchange-traded fixed income derivatives.
As of the end of June 2001, notional amounts outstanding of fixed income derivatives
totaled $861 billion in emerging markets, compared with notional amounts outstanding
of $93.306 trillion in global markets.
Equity index derivatives are actively traded in Korea, Hong Kong, Taiwan, Brazil,
and South Africa. As of the end of June 2001, notional amounts outstanding of equity
derivatives totaled $51 billion in emerging markets, compared with notional amounts of
$3.944 trillion in global markets.
Sovereign credit default swaps are the most liquid instruments in emerging market
credit derivatives. Local credit derivatives activity has been picking up in some emerg-
 March–April 2008 41

ing markets, most notably in Brazil and South Africa. Size estimates of emerging credit
derivatives markets range from the outstanding notional amount of $40 billion as of
mid-2001, according to Risk Survey, to between $200 billion and $300 billion suggested
by Deutsche Bank (IMF 2002; Ranciere 2002).

The Role of Derivatives in Emerging Markets

Commodity Derivatives
Commodity futures markets offer a mechanism for dealing with the price risks that
primary commodity producers face. This is of particular relevance to emerging market
economies because the effect of price volatility on producers in these economies is much
greater than it is for those in developed economies. Some emerging market economies
rely heavily on one or two commodities for their export earnings, leaving macroeconomic
conditions very vulnerable to shocks in commodity prices.
Policies designed to counter the effects of the inherent instability of commodity
markets have taken various forms since the 1930s. Keynes (1938) proposed a series of
international buffer-stock schemes to compensate for low levels of private storage in
commodity markets. Buffer-stock schemes were promoted through the establishment
of the International Commodity Agreements (ICAs) from the 1930s to the 1980s; for a
detailed review of the earlier history of these and other policies, see Gordon-Ashworth
(1984). Gilbert (1996) examined the factors and problems leading to the death of ICAs.
Gemmell (1985), Gilbert (1985), and Hermann and Burger (1993) compared the effect
of futures markets and buffer-stock schemes, highlighting the fact that futures markets
offered a more effective and welfare-improving method of dealing with price volatility.
Morgan (2001) offered a background study on policy attempts to reduce the effects of
price volatility on primary commodity markets and reviewed the roles of futures markets
in less developed countries (LDCs) and the current extent of the development of futures
markets trading in LDCs. The paper demonstrated that for more extensive use of com-
modity futures markets, it is critical to persuade LDCs’ governments and traders that they
are being offered a realistic, low-cost, and relatively risk-free chance to cover some of
their price risks. Claessens and Coleman (1991) studied Papua New Guinea, a country
that faces substantial price risks for its major primary commodity exports, including gold,
copper, coffee, cocoa, logs, and palm oil. To demonstrate the benefits of market-based
financial instruments, the authors showed that commodity futures, commodity options,
commodity swaps, and commodity-linked finances are better suited to manage external
price risk for a price-taker country in international commodity markets. Using world
coffee price data from 1980 to 1989, Claessens and Coleman (1991) demonstrated that
a hedging strategy using futures contracts could reduce the intrayear variability of cof-
fee prices from 10.5 percent on average to 0.4 percent, indicating that the producers are
almost entirely insulated from intrayear price fluctuations. Among market-based instru-
ments, commodity futures and options could eliminate the short-term price exposure
of agricultural products, whereas commodity swaps could be used for long-term price
exposures related to mineral and energy commodity products (see also Masuoka 1990;
Morgan 2001).
Claessens and Varangis (1991) showed how a developing country’s state oil-
importing company could use futures and options contracts to insure against price fluc-
tuations in crude oil. They simulated short-term hedge scenarios, in which the company
42 Emerging Markets Finance & Trade

locked in a price for its one-month-ahead crude oil imports, and long-term hedge sce-
narios, in which the price was locked for six-month-ahead imports. It was shown that the
short-term and long-term hedge strategies could potentially reduce the price volatility by
72 to 85 percent and 65 to 81 percent, respectively.
However, the effectiveness of a hedging strategy could be reduced by various con-
straints. Gilbert (1985) highlighted that if credit is constrained and the costs of using
futures contracts are high, then the hedging effectiveness of futures market is greatly
reduced. Claessens and Varangis (1991) identified four factors that constrained the use
of risk management techniques—namely, cash flow, negative publicity, flexibility of
action, and the legal system.

Financial Derivatives
Financial derivatives are important to hedging and risk management because they facilitate
capital flows to developing economies. However, they also create the possibility of raising
risk in financial systems, generating more unpredictable crisis dynamics, and providing
a transmitting channel for contagion. Studies of emerging market crises revealed that
financial derivatives can play both positive and negative roles (see, e.g., Dodd 2000; IMF
2002; Garber 1998; Kregel 1998).

Financial Derivatives and International Capital Flows

The rapid expansion of financial derivatives products during the past ten to fifteen years
was important in facilitating the growth of global cross-border capital flows in the 1990s.
Financial derivatives unbundle the risks associated with traditional cross-border invest-
ment vehicles, such as foreign exchange, interest rate, market, credit, and liquidity risks.
They redistribute these risks from investors who do not want them to those who are in a
better position to manage them. Cross-border investments are thus more attractive, leading
to increased net flows and more opportunities for portfolio diversification. On the other
hand, financial derivatives can be used to enhance risk, evade prudential regulations, and
avoid capital controls and taxes. The misuse of financial derivatives lays the foundation
for financial crisis, and financial derivatives can accelerate capital outflow during a crisis.
As a consequence, the volatility of international capital flow increases, which exacerbates
the crisis by rendering the dynamics of crisis more unpredictable.
Dornbusch et al. (2000) highlighted that, in general, international capital markets ap-
pear volatile, on both the downside and the upside. In the mid-1990s, aggregate private
capital flows into five crisis-affected East Asian countries—Indonesia, Korea, Malaysia,
Philippines, and Thailand—averaged more than $40 billion per annum, reaching a peak
of about $70 billion in 1996. In the second half of 1997, more than $100 billion in bank
loans were recalled from these five countries, currencies sharply depreciated, and stock
markets collapsed. Just as inflows in the early 1990s and increases in markets prices
added to the credit booms in many East Asian countries, outflows in 1997 severely ag-
gravated the East Asia financial crisis. An immense amount of research has attempted to
understand the exact causes of the volatility in international capital flows. Dornbusch et
al. (2000) provided an excellent review. Dodd (2000), Garber (1998), and Kregel (1998)
more extensively discussed the specific roles of financial derivatives in international
capital flows. Table 1 summarizes the examples of derivatives transactions referred to
in the literature.
Table 1. Financial derivatives and their roles in financial crisis
Derivatives Description Negative effects References

Total return swaps (TRS) One party pays LIBOR to the counterparty, which in exchange pays Disguise the nature of the Garber (1998)
Tesobono Swaps the total rate of return on a security issued by the government of an risk exposures Kregel (1998)
emerging economy, or the rate of return on a loan involving credit risk Promote crisis-driven Dodd (2000)
of another country. A TRS replicates a cash position of borrowing at capital outflows Neftci (2000)
LIBOR and investing in a security or security index in local currency, Increase the risk of
a transaction to benefit from the interest rate spread between LIBOR contagion
and the local market. The mismatched transaction, however, does not
involve ownership or debt, and hence, has no effect on a firm’s
balance sheet.
Equity swaps One party pays LIBOR to the counterparty, which in exchange pays Disguise the nature of the Garber (1998)
the total rate of return on an equity issued by a company in an risk exposures
emerging market economy. Promote crisis-driven
capital outflows
Structured notes All structured notes provide means to increase returns for investors, Leverage up exposure Garber (1998)
PERL with higher risk embedded in the package, which could be sales of Dodd (2000)
interest rate options in the case of structured credit notes; exchange
of the credit risks associated with an instrument in the case of credit-
linked notes with credit swaps embedded; or with the interest payment
or the principal value linked to an index representing a foreign asset,
resulting in exposure to exchange-rate risk in the case of PERL. By
investing in a structured note such as PERL, a financial institution has
taken on more market risk without a commensurate change to its
capital requirement (i.e., leveraged-up capital positions).
Loans with put options Loans with put options or putable bonds embed put options on the Promote crisis-driven Dodd (2000)
Putable bonds debt principal, enabling lenders to recall their principal in the event of capital outflows
economic trouble. The effect is to drain the emerging financial markets
of liquidity just at the time it is most urgently needed.
March–April 2008

Note: LIBOR = London Interbank Offered Rate

43
44 Emerging Markets Finance & Trade

Garber (1998) analyzed the twofold role of derivatives in international capital flows.
Using currency and interest rate swaps as examples, the author showed that derivative
products help in the growth of cross-border capital movements, in both gross and net
international flows. Notwithstanding the ability to separate market risks, derivative
products can disguise the nature of the risk exposures that the counterparties assume
(as in Tesobono swaps), leverage up exposure volume (as in structured notes), and blur
transactions reporting (as in equity swaps), all of which are potentially destructive to
emerging market economies. The author also analyzed the role of derivatives in crisis-
driven capital outflows, from causes of the crisis (e.g., speculative attacks on a currency)
to effects of the crisis (e.g., liquidity pressure resulting from margin calls, as in equity
and Tesobono swaps).
Kregel (1998) analyzed channels through which bank derivative contracts may have
been linked to the rise in short-term bank lending to Asia, examining structured notes,
including structured credit notes with embedded options; U.S. government agency
dollar-denominated structure notes, the interest payment or the principal value of which
was linked to an index representing some foreign asset; and credit-linked notes with
credit swaps embedded in structured notes. Structured derivative packages, the use of
which expanded dramatically during the 1990s, were the means to overcoming the in-
vestment regulations applied to U.S. institutional investors. The investment regulations
restrict investment to assets with an investment grade credit rating and preclude certain
types of risk, such as foreign exchange risks or foreign credit risk. Moreover, because
most of the risk of these structured notes resides with the investors or borrowers, the
financial institutions are more concerned with maximizing fees and commissions than
profits by seeking the lowest-cost funds and continuous risk assessment and monitor-
ing. Thus, derivatives construct means for financial intermediaries to increase the rate
of return on their capital (by increasing the rate of flow) as they increase the risks borne
by their counterparties. The result offers little support for the common belief in the self-
regulating nature of private capital markets, in terms of risk assessment or their ability
to allocate capital efficiently. To show the importance of derivative products in banking
activities in Asia, Kregel (1998) cited the Country Exposure Lending Survey for U.S.
money-center banks published by the Federal Financial Institutions Examination Council
(FFIEC, Country Exposure Lending Survey /1, table 1, pp. 18–19, April 8, 1998). As of
December 31, 1997, for U.S. money-center banks, cross-border exposure from foreign
exchange revaluation and derivatives exceeded the total amount owed for traditional
lending in Thailand. The corresponding figure was well over half of the total lending
for Korea and roughly two-thirds of that of Indonesia. The majority of losses that major
U.S. money banks reported on their Asian lending were listed as swaps. Clearly, Ger-
man and French banks were also involved in derivatives trading in the regions. Deutsche
Bank recorded losses of as much as $100 million on derivatives trading in South Korea,
Thailand, Indonesia, and Malaysia.
Dodd (2000) studied the role of derivatives in the East Asian financial crisis. Analyz-
ing various derivative products in East Asian economies, including foreign exchange
forwards and swaps, interest rate swaps, total return swaps, structured notes, and putable
loans, the author showed that, on one hand, derivative products facilitated capital flows
to Asia in the 1990s by unbundling and redistributing risks; on the other hand, deriva-
tives facilitated unproductive activities and lowered safeguards. At the onset of financial
crisis, the unwinding of derivative positions accelerates capital outflows from emerging
market economies, which increases the pace and deepens the effect of the crisis. First,
 March–April 2008 45

in the event of devaluation or a sharp downturn in securities prices, collateral or margin

requirements in derivative transactions could result in a large and immediate surge in
foreign currency transfers out of emerging market economies. To indicate the potential
magnitude of the collateral outflows in financial crisis, Garber and Lall (1996) cited IMF
and industry reports that Mexican banks held $16 billion in Tesobono total return swaps
at the time of the Mexican peso devaluation. The authors calculated that the initial peso
devaluation depressed the value of Tesobonos by 15 percent, which would have required
the delivery of $2.4 billion in collateral the next day. This number would explain about
half of the $5 billion dollars of foreign reserves lost by the Mexican Central Bank the
day after devaluation.
Second, some financial derivative instruments, such as loans with put options, cre-
ate liquidity shortages in the event of a financial disruption—that is, when liquidity is
crucial for the successful functioning of the financial sector. Dodd (2000), citing IMF
numbers, showed that putable bonds issued from East Asia and due in 1999 or 2000 to-
taled $10.6 billion. The number of loans with put options totaled $10.5 billion. Another
related issue is the role of financial derivatives in reducing the transparency of financial
reporting as it pertains to individual banks and capital accounts in the national balance
of payments. Derivative products enable firms to remove certain exposures from balance
sheets, magnifying balance sheet mismatches of financial institutions and disguising
these mismatches so that prudent supervisors cannot detect them easily. Neftci (2000)
highlighted that in South Korea, short-term off balance–sheet loans secured by banks
were around $20 billion, compared with total short-term liabilities of South Korea in
November 1997 of $80 billion.
Derivative products could further result in misreporting a country’s balance of pay-
ments. Dodd (2003) analyzed total return swaps (TRSs) used by local financial institu-
tions in East Asia and Mexico before financial crises from 1997 to 1998 and in 1994,
respectively. As the mismatched transactions of TRSs did not involve ownership or debt,
they did not affect company balance sheets. The result was a deviation of an entity’s
risk exposure from that reflected in its balance sheets or official reports. TRSs also alter
the form of capital flows to developing countries, causing misreporting of a nation’s
balance-of-payments accounts. Instead of recording capital flows in the form of short-
term, hard currency bank loans, the capital flows of TRS transactions were recorded as
a local currency–denominated security and an outflow of bank deposits related to the
payment of collateral by the local bank.

Financial Derivatives and Currency Crisis

There are several explanations for the occurrence of financial crises. Cavalleri and
Corsetti (1997) and Corsetti et al. (1999) constructed formal models to analyze the
causes and consequences of a financial crisis (for a review, see Flood and Marion 1999).
Claessens and Glaessner (1997) provide background reading for the Asian crisis. Neftci
(2000) developed a framework explaining the dynamics of a financial crisis. A partial
list of recent analyses of the Asian crisis includes Alba et al. (1998), Corden (1998),
Dornbusch (1998), Feldstein (1998), Goldstein (1998), IMF (1998), and Radelet and
Sachs (1998). There is now a consensus that, though derivatives did not cause the crisis,
they amplified its effects on the financial systems of emerging market economies. Dodd
(2000; 2003), Garber (1998), and IMF (2002) analyzed the role of financial derivatives
in a currency crisis.
46 Emerging Markets Finance & Trade

Garber (1998) described the mechanics of a speculative attack on a fixed exchange

rate system, explaining how transactions in a forward exchange market threaten the
stability of such systems. A forward sale of weak currency immediately generates a
spot sale of the weak currency by the counterparty bank. In its campaign to defend the
exchange rate, the central bank either buys domestic currency in the forward market, thus
supplying credit directly, or provides credit to the counterparty bank through its money
market operations or its standing facilities. Either method leads to an excessive supply
of the weak currency and an increase in capital outflows, resulting in steep devaluation
and currency crisis.
Dodd (2003) noted that the presence of a market for foreign exchange derivatives could
undermine the stability of a fixed exchange rate system in several ways. First, by provid-
ing greater leverage with smaller transaction costs, foreign exchange derivatives lower
the costs of betting against the fixed exchange rate, encouraging speculative behavior.
Second, the presence of foreign exchange markets means that the central bank must peg
the exchange rate not only in the spot markets, but also in the forward and swap market
for foreign currency. Together they enlarge the critical size for a successful central bank
intervention. Third, the price discovery process in foreign exchange derivatives markets
indicates a future devaluation under many circumstances. When interest rates in emerging
market economies are higher than they are in developed economies, which is usually the
case, the interest rate differential is reflected in the equilibrium forward rates, indicating
that the currency depreciates at the same rate as the interest rate differential. Furthermore,
when there is a high demand for foreign currency, the foreign currency market makers will
only provide forward contracts with a market risk premium. This is because the market
makers use the local credit market to lay off their position in forward market. They need
to borrow in the local currency, buy the foreign currency with the borrowed funds, and
invest in foreign currency assets for delivery at the maturity of the forward contract. If the
local currency credit markets are not perfectly efficient, the market makers add a market
risk premium to the interest rate differential when quoting forward rates. Consequently,
the forward rates indicate a greater rate of depreciation.
Financial derivatives allow market participants to establish leveraged positions, but
they also can raise the level of risk relative to capital, magnifying the adverse conse-
quences of a negative shock in the markets and increasing system risk. Garber (1998)
analyzed structured notes transactions in which a Mexican bank or its foreign subsidiary
bought a note with a twenty-nine-day maturity from a New York investment house for
$10 million, with both the principal and interest payment linked to the peso value of the
dollar at maturity. According to the payoff formula, the initial $10 million investment
was leveraged threefold. Dodd (2003) elaborated this point with the example of PERL,
a structured note with principal linked to the exchange rate. By investing in a PERL,
a financial institution takes on more market risk without a commensurate change to its
capital requirement—that is, leveraged-up capital positions.

Financial Derivatives and Contagion

Many studies have been conducted to understand the causes and effects of contagion,
the tendency for a financial crisis in one country to adversely affect the financial markets
in other economies (see, e.g., De Bandt and Hartmann 2000; Dornbusch et al. 2000;
Forbes and Rigobon 1999; Krugman 2001; Pritsker 1999; Wolf 1999). Formal analyti-
cal multiple equilibrium models have been developed to explain recent experiences in
 March–April 2008 47

emerging markets (see Chang and Majnoni 1999; Gerlach and Smets 1995; Jeanne 1997;
Masson 1998). Bekaert and Harvey (2003) reviewed the literature on contagion in the
context of emerging market finance. Dungey et al. (2005) reviewed methodologies for
empirically modeling contagion.
To assess the effect of financial derivatives on contagion in the context of currency
crisis, studies have examined the effect of the probability of a speculative attack that stems
from attacks on other currencies (see, e.g., De Gregorio and Valdes 2001; Eichengreen
et al. 1996), finding that the probability of a domestic currency crisis increases with a
speculative attack elsewhere. Esquivel and Larrain (2000) documented evidence of re-
gional contagion, in which a currency is more likely to devalue if a neighboring country
has experienced devaluation, controlling for other determinants of devaluation. Dodd
(2000) highlighted that derivatives can spread the stress or crisis in one country to another
because of a rapid expansion of counterparty credit risk during the period of economic
stress. Contagion also comes from the practice of financial institutions responding to a
downturn in one market by selling in another to obtain liquid assets to meet collateral
or capital requirements.
Neftci (2000) adopted a total return-swap example to analyze the role of derivatives
in contagion effects. In the example, an international bank lends money to an Indonesian
corporation and swaps the return involving Indonesian corporate risk against a lower
return involving a South Korean bank risk. On top of this regular exchange of cash
flows, the swap counterparties agree that if the Indonesian borrower goes bankrupt, the
South Korean bank will compensate the international bank for the loss. Thus, the South
Korean bank is exposed to Indonesian credit risk. During a financial crisis in Indonesia,
the South Korean bank taking over Indonesian credit risk could become insolvent, as it
could not be expected to generate a payment sufficient to cover the international bank for
a loss in the range of $100 million. When the Korean bank defaults on its commitments
to an international bank, it is also likely to default on its loans from Japanese banks. A
financial crisis in Indonesia would thus be transmitted first to South Korea and then to
Japan; it would become contagious. The Korean bank’s exposure to Indonesian credit
is not visible on their balance sheets because the exposure is covered through the total
return swap instead of from direct lending. In this sense, derivatives not only create the
possibility for contagion, but also make the contagion unpredictable.

Case Studies
Studies of cases related to the role of financial derivatives focus mainly on two issues.
One is to explain how the use of derivatives before the onset of a crisis affects the stabil-
ity of domestic financial systems. The other is to highlight the effects of the unwinding
of derivatives positions on the crisis dynamics after the onset of a crisis and contagion
effects.
Kregel (1998) described the lawsuits filed by a number of Korean entities that were
swap counterparties of JP Morgan. Citing the AP-DJ New Service, in early 1998, JP
Morgan has a total exposure of $3.4 billion to Korea, of which $2 billion was for de-
rivatives products. Two transactions related to the lawsuits were described in detail.
One was a dollar-to-won currency swap between JP Morgan and Boram Bank, which
passed on the exchange rate risk to SK Securities through a series of swaps. As a result,
SK Securities carried the foreign exchange risks, but borrowed at cheap dollar interest
rates against the won it was lending to its clients at call market rates, which were about
48 Emerging Markets Finance & Trade

twice as high as dollar rates when the swap was initiated. SK Securities thus bore the
exchange rate loss on the swap, as it owed this sum to Boram, which in turn owed it to
JP Morgan. This suit placed the value at $189 million, suggesting the potential losses
involved and why there was pressure on the foreign exchange market to acquire funds
to unwind swaps of this nature.
IMF (2002) reviewed cases during the Mexican crisis in 1994, the Asian crises in
1997–98, Russia’s default and devaluation in 1998, and Argentina’s default and devalu-
ation in 2001–2. The Mexican and Asian crises highlighted the role of structured notes
and swaps in magnifying balance sheet mismatches and the associated volatility in for-
eign exchange markets. The Russian and Argentine crises demonstrated the importance
of counterparty risk and spillover through credit markets. Citing market sources, IMF
(2002) reported that the U.S. dollar-to-ruble foreign exchange forwards with Russian
firms as counterparties were the largest source of credit losses by major swap dealers
during 1997–98, exceeding the losses made on their Asian lending. Russia’s default also
highlighted legal issues, such as definitions of credit events and reference obligations,
which led to difficulties for protection buyers in enforcing the contracts. To address these
issues, the International Swaps and Derivatives Association (ISDA) issued new credit-
derivative documentation guidelines in 1999.
Schmukler and Serven (2002) investigated the patterns and determinants of the currency
risk premium in two currency boards, Argentina and Hong Kong. In the case of Hong
Kong, the paper highlighted the effect of speculative attacks on the pegged exchange
rate through substantially increased currency premiums and market volatility. Starting
with 2,240 observations of currency premiums for Hong Kong calculated from the one-
month forward discount from January 4, 1993, to June 5, 2001, the authors differentiated
between tranquil and crisis periods. There were 332 observations during seven crisis
periods—namely, the Mexican crisis (January 10, 1995, to April 10, 1995), early signs
of financial distress in South Korea (January 27, 1997, to February 21, 1997), the attack
on the Thai baht (May 14, 1997, to July 24, 1997), the first attack on the Hong Kong
dollar (August 15, 1997, to December 15, 1997), the second attack on the Hong Kong
dollar (January 5, 1998, to February 4, 1998), the third attack on the Hong Kong dollar
(May 27, 1998, to July 6, 1998), and the fourth attack on the Hong Kong dollar (July 10,
1998, to October 6, 1998). Empirical analysis indicated that the sample means of the
currency premium implied by one-month deliverable forwards were close to zero and
301 basis points in tranquil and turbulent periods, respectively. A prolonged period of
turbulence surrounded the East Asian crisis. The most noticeable events that kept the cur-
rency premium high were the second, third, and fourth attacks on the Hong Kong dollar,
during which the currency premium averaged over 400 basis points and reached 598 basis
points in the second attack. The standard deviation was 293 basis points, compared with
a standard deviation of 53 basis points in tranquil periods.

Functions of Emerging Derivatives Markets

Risk Reduction/Redistribution
It is widely accepted that the primary function of the derivatives market is to facilitate
the transfer of risk among economic agents. Various instruments traded in derivatives
markets provide different packages of payment patterns, redistributing and reallocating
the risks associated with future cash flows among different market participants.
 March–April 2008 49

The process of using derivative instruments to reduce or eliminate risks is often de-
scribed as hedging; traders performing hedging transactions are hedgers. This section
reviews the research on the function of emerging derivatives markets in hedging price
risks associated with commodity and financial products, and summarizes the studies on
optimal hedging strategies.

Commodity Futures Market

By taking a position in the futures markets that is opposite to that held in the spot market,
a hedger can potentially offset losses in the latter with gains in the former. The organized,
standardized, and centralized nature of futures exchanges means that risks are borne by
others, such as speculators, in return for a premium. Thompson (1985) reviewed the use
of futures markets for exports by LDCs. Futures contracts can be applied to remove un-
certainty regarding export price levels (Gordon and Rausser 1984; Newbury and Stiglitz
1981; Rolfo 1980). Ramaswami and Singh (2006) demonstrated the hedging function
of soya oil futures contracts in India. The relation between futures prices for different
maturities provides information regarding the availability of stocks to the market, which
facilitates inventory hedging (see, e.g., Peck 1975; Thompson 1985; Working 1949).
Martin and Hope (1984) discussed inventory hedging strategies comparing different
marketing strategies for Canadian corn producers. On the other hand, various research-
ers (e.g., Peck 1976; Thompson 1985) noted that hedging in commodity futures markets
does not entirely remove uncertainty in the net price that exporters eventually receive.
The revenue of a producer is affected by variability in basis, which is the difference be-
tween the cash and futures prices at the delivery location, and the uncertainty of realized
harvest if the exports are priced before the availability is known. Telser (1981) showed
that complete price insurance is only possible if spot and futures prices move exactly
together. If not, then perfect insurance is not feasible (Thompson 1985).
A related topic is the use of futures markets to provide price support. Exporters may
attempt to support cash market prices by trading futures collectively. Their strategy would
be to purchase futures contracts and hold the cash commodity in an amount sufficient to
create upward pressure on futures- and cash-market prices. Varangis and Larson (1996)
offer several examples, such as cotton and oil in Mexico and oil in Algeria. Other examples
can be found in Claessens and Duncan (1993) and World Bank (1999). However, exporters
considering price manipulation through futures trading run the risk of regulatory actions. The
1977 coffee episode stirred debate over the proper regulation of international futures trading
(Greenstone 1981). Long-run prospects for successful price manipulation through futures
trading are poor. Researchers have documented cases in which hedgers and speculators
lost interest in futures trading when prices were effectively stabilized by the activities of a
single government or organization. Gray (1960) described the demise of futures trading in
coffee in 1950 in relation to the manipulative and price-supporting actions of Brazil.

Financial Derivatives Market

Market participants can use financial derivatives in many ways to redistribute risks and
facilitate cross-border capital flows into emerging market economies. IMF (2002) gave
examples illustrating the use of derivatives in this regard, including currency derivatives
that help to hedge investments against unexpected changes in exchange rates and interest
rate swaps that enable corporations and banks to exploit their comparative advantages
50 Emerging Markets Finance & Trade

in borrowing at fixed versus floating rates in different markets. Citing the 1995 Bank
for International Settlements (BIS) survey, Garber (1998) showed that if applied one-
to-one to outstanding securities, the stock of OTC derivatives—which stood at $47.5
trillion in March 1995, and which about 55 percent were cross-border transactions and
exchange-traded derivatives amounting to $8 trillion—were sufficient to repackage the
risk characteristics of all domestic and international securities and international banking
assets, given that the total stock of domestic and international securities in the Organiza-
tion for Economic Cooperation and Development (OECD) countries was $26.3 trillion,
and that international banking assets, excluding securities holdings, were $8.3 trillion in
March 1995.
Recently, functions of nondeliverable forwards (NDFs) have attracted more attention.
NDFs are forward transactions that are settled by a cash payment in U.S. dollars reflect-
ing the market value of the contract, so that no local currency changes hands. NDFs are
mostly used for emerging market currencies. The most important NDF currencies are
the major currencies in Asia, the Argentine peso, the Brazilian real, and the Hungarian
forint. Offshore NDF markets form an important part of the global and Asian foreign
exchange markets, equilibrating market demand and supply under capital controls (Ishii
et al. 2001; Watanabe et al. 2002). Jiang and McCauley (2004) showed that NDF markets
could potentially facilitate foreign investment in Asia’s expanding local currency bond
markets and thereby add diversity and liquidity to these markets.
Ma et al. (2004) examined the markets for NDF in six Asian currencies: the Indian
rupee, Indonesian rupiah, Korean won, Philippine peso, New Taiwan dollar, and Chi-
nese renminbi. The turnover of NDF markets of these currencies represents the bulk of
global trading in NDFs, 70 percent as measured by an Emerging Markets Traders As-
sociation survey in early 2003. Korean-won NDFs are the most actively traded. Asian
NDF markets amounted to a substantial share of onshore outright forward and foreign
exchange swap turnover in the same currencies, representing some 10 to 20 percent of
the combined trading volume of the onshore outright forwards. Aggregate turnover in
regional NDFs has increased from $920 million in June 2001, as estimated by Lehman
Brothers, to $2.25 billion in mid-2003, as estimated by HSBC Bank. The larger and
more active NDF markets in Asia—those of the won, the New Taiwan dollar, and the
renminbi—are comparatively more liquid. Asian NDF markets have attracted extensive
investor participation, including multinational corporations, portfolio investors, hedge
funds, and proprietary foreign exchange accounts of commercial and investment banks,
representing both hedging and speculative demands.

Optimal Hedging Strategy

The hedging role of derivatives hinges on formulating and implementing an optimal
hedge strategy. At the theoretical level, an optimal hedge strategy is traditionally based
on the expected utility maximization paradigm. The literature on hedging within the
expected utility framework is immense, including, among others, Adam-Muller (2000),
Briys et al. (1993), Broll and Zilcha (1992), Broll et al. (1995), Ederington (1979), John-
son (1960), Stein (1961), and Zilcha and Eldor (1991). The analysis frequently reduces
the objective of expected utility maximization to that of variance minimization. Recent
theoretical literature evaluates alternative approaches. First, it is argued that as far as
hedging is concerned, a one-sided measure such as the downside risk is more relevant
(see, e.g., Bawa 1975, 1978; Grant et al. 2001; Kang et al. 1996; Lien 2001a, 2001b).
 March–April 2008 51

Second, developments in the stochastic dominance literature, such as the mean Gini
approach, facilitate implementing a hedge strategy (see, e.g., Shalit and Yitzhaki 1984).
At the empirical level, much research has been done on improving the estimation of the
optimal hedge ratio.1 Lien and Tse (2002) surveyed developments in optimal hedging
strategies. There are alternative instruments available for hedging purposes; among them,
perhaps the most important one is options.2

Optimal Hedging in Commodity Derivatives Markets. The use of futures markets for
exports by LDCs has been suggested as a better alternative to improve LDCs’ exporting
performance. Various papers have discussed optimal hedging strategies in commodity
markets incorporating price uncertainty, production uncertainty, and price–quantity
correlation considerations. Peck (1975) analyzed the optimal hedge strategy for an egg
producer, emphasizing price uncertainties on the cash market and on the basis on delivery
date. It was found that, without production uncertainty, a producer should hedge between
75 to 95 percent of the output. Rolfo (1980) examined cocoa producers and demonstrated
that for a risk-averse producer, the optimal hedge position is much less than the expected
output when both price and production are uncertain. To some degree, futures markets
can protect against adverse cash-market price changes, but they may provide little revenue
protection. Assuming a logarithmic utility function, the optimal hedge ratios were 0.15
for Ghana, 0.13 for Nigeria, 0.3 for the Ivory Coast, and 0.45 for Brazil. The optimal
hedge ratios were 0.61, 0.65, 0.78, and 0.94 for the four countries, respectively, in the
mean–variance framework.

Optimal Hedging in Financial Derivatives Markets. The literature on optimal hedging in

financial derivatives markets focuses on currency risk. Theoretical research on hedging
with currency risks in international portfolios shows that within the international asset-
pricing framework of Solnik (1974), optimal portfolios contain positions in forward
contracts, or equivalent foreign currency–denominated bills. At the empirical level,
research has concentrated on the benefits of fully hedging the exchange risk (see, e.g.,
Bekaert and Hodrick 1992; Eun and Resnick 1988; Jorion 1989; Kaplanis and Schaefer
1991; Perold and Schulman 1988).
A related topic is the implementation of an optimal futures hedging strategy in the
presence of multiple risks. Analytically, Lypny (1988) and Lien (1990) demonstrated that
hedging multiple spot assets with multiple futures contracts produces a portfolio effect
on the hedging effectiveness measure. Hedging effectiveness is a measure assessing how
effectively a hedging strategy reduces the risks associated with a portfolio. Hedging ef-
fectiveness is also a key condition applied in hedge accounting rules (see below).3
Glen and Jorion (1993) examined the benefits from currency hedging in international
bond and equity portfolios. The authors compared the risk-return performance of globally
diversified portfolios with and without forward contracts from 1974 to 1990. The results
showed that, following an unconditional hedging strategy, including forward contracts
statistically significantly improved portfolio performance. Conditional hedging strategies,
which allow the hedge ratios to vary over time, were shown to outperform unconditional
hedging strategies.
Lien and Wong (2004) investigated the optimal bidding and hedging decisions of a risk-
averse contractor for a construction project abroad. The contractor has uncertain foreign
exchange exposure because the foreign currency cash inflow materializes only when the
contractor ultimately wins the tender. By developing theoretical models and providing
52 Emerging Markets Finance & Trade

a canonical example, the authors argued that currency options play no role as a hedging
instrument when the contractor has a quadratic utility function, but prudence generates
a hedging demand for currency options when foreign exchange exposure is uncertain.
On the other hand, currency hedging may have perverse effects on the contractor’s bid-
ding behavior; there are possibilities for the contractor to bid more aggressively without
currency hedging.
To seek the optimal hedging strategies against the local currency–U.S. dollar exchange
rate risk that depository financial institutions face in a selected group of emerging Asian
countries, Mun and Morgan (1997) contrast the minimum variance cross-hedge strategy
with a futures portfolio and minimum variance cross-hedge strategy with only a single
currency futures contract. The portfolio includes the British pound, Canadian dollar, Ger-
man mark, and Swiss franc futures contracts. Measuring hedging performance with the
Sharpe performance index, empirical findings suggest that the futures portfolio strategy
performs better than the single currency futures strategy for Singapore and Thailand, at a
significance level of 0.01 and 3.9 percent, respectively. In contrast, for Korea and Malaysia,
the single currency futures strategy outperforms the futures portfolio strategy. No real
conclusion can be drawn as to which strategy will work every time for every country.
Kroner and Claessens (1991) presented a model showing that the currency composition
of a country’s external debt can be a hedging instrument against changes in exchange
rates and commodity prices. The authors derived a sequence of optimal dynamic hedging
portfolios that can be estimated with a multivariate generalized autoregressive conditional
heteroskedasticity (MGARCH) model, allowing the second moments to change over
time. The model was applied to Indonesia to illustrate the usefulness of the technique.
The result suggested that Indonesia’s optimal debt portfolio should consist of a much
larger proportion of U.S. dollars and a much smaller proportion of Japanese yen than
Indonesia had in its current debt portfolio.

Price Discovery
Trading in futures and options incurs a smaller transaction cost than does trading in the
spot market. Introducing either derivative is expected to increase information flows into the
market, leading to a price-discovery function in the derivatives market. The futures price
contains information about anticipated demand that can feed into production decisions.
Mayhew (2000) reviewed the literature on the price discovery function of derivatives mar-
kets. A popular approach to test for this function is to study the lead–lag relations between
price changes in cash and derivatives markets. Empirical evidence on stock index futures
markets in the United States and other developed economies overwhelmingly indicates
that index futures lead the reported values of the underlying cash index, with estimates
of the lead time ranging from five to forty-five minutes.4 Some studies report evidence
of a much shorter lead in the opposite direction, with cash markets occasionally leading
futures markets by one or two minutes, as occurs in France (Shyy et al. 1996).
In emerging derivatives markets, Min and Najand (1999) investigated lead and lag
relations in returns between cash and futures markets in Korea, finding that the futures
market leads the cash market by as long as thirty minutes. To assess the price-discovery
function of the Athens Derivatives Exchange (ADEX), Kenourgios (2004) examined the
price movements of FTSE/ASE-20 three-month futures and the underlying FTSE/ASE-
20 index cash market in the Athens Stock Exchange (ASE). The futures contract of the
FTSE/ASE-20, which started trading in 1999, is the main derivative instrument in the
 March–April 2008 53

ADEX. The Engle–Granger and Johansen methods were both applied to test for coin-
tegration between the spot index and the futures markets. The results suggest the two
markets are cointegrated, and hence, an error-correction model is developed to investigate
the lead–lag relation between the two markets. Empirical analysis indicates bidirectional
causality, or a feedback relation, between the spot and the futures markets: Each market
contains useful information regarding consequent price movements in the other market.
The author concluded that the futures contract was a focal point of information assimila-
tion, fulfilling the price-discovery function.
Beelders and Massey (2002) analyzed the interrelations between all shares, gold and
industrial indexes of the Johannesburg Stock Exchange, and the corresponding index
futures contracts traded on the South African Futures Exchange after electronic trading
was introduced. The authors found that the three indexes and their futures prices were
cointegrated. Using a vector error-correction model (VECM) showed that, after the in-
troduction of electronic trading, the spot and futures markets responded more quickly to
their own shocks and shocks from the other market. For the spot market, the coefficient
for the lagged conditional variance increased from 0.6501 to 0.9706; for the futures
contracts, it increased from 0.8251 to 0.9754. The contemporaneous correlation between
the two markets also increased from 0.7552 to 0.8055.
The price-discovery function of credit derivatives is discussed in IMF (2002; 2003).
Useful information on default probabilities for a sovereign at different time horizons
could be extracted using standard credit-default swap valuation models. The IMF (2002;
2003) examines the evolution of default probabilities for Argentina at one- and two-year
horizons between August 1998 and February 2002. Default probabilities were estimated
using the credit-default derivatives pricing model described in Duffe (1999) and as-
suming a 25 percent recovery rate in case of default. The report illustrated that default
probabilities were lower than 20 percent at the end of 2000. Increased concerns about
Argentina’s ability to meet its debt payments caused default probabilities to creep upward
during 2001. In August 2001, the one-year horizon sovereign credit-default probability
was at about 40 percent and that for the two-year horizon was at about 60 percent. By
the end of the second half of 2001, default probabilities reached levels over 80 percent.
The numbers highlight that credit-default swaps convey useful information about the
market views on a sovereign state’s ability to honor its external debt and the recovery
value bond investors can obtain in case of debt default. Cash market instruments also
contain information about sovereign risk: Sovereign bond spreads are useful indicators
of sovereign debt solvency. However, the price-discovery function of the credit deriva-
tives market is important because liquidity in the cash market is more likely to dry out
during periods of stress than it is in the credit-default swap markets.

Price Stabilization
Futures markets ensure a more efficient process of private storage: By insuring against
price losses, futures markets encourage storage, which is a natural mechanism to stabi-
lize spot prices. It is therefore hypothesized that futures markets will reduce spot price
volatility. A variety of theoretical arguments have been advanced to explain why and how
the existence of derivatives markets might affect the volatility of the underlying asset
market. If the market is not perfectly competitive, introducing futures may induce large
producers to manipulate cash prices through production and storage decisions, increasing
spot price volatility (Mayhew 2000).
54 Emerging Markets Finance & Trade

Various aspects of the relations between futures markets, storage, and production
were modeled by Chari and Jagannathan (1990), Chari et al. (1990), Kawai (1983),
Peck (1976), Sarris (1984), and Turnovsky (1979). Bray (1981), Danthine (1978), and
Grossman (1977) developed fully revealing rational-expectations equilibrium models for
futures markets. Weller and Yano (1987) analyzed the effect of futures markets on spot
prices in a general equilibrium model of an exchange economy. Newbery (1987), Stein
(1987), Subrahmanyam (1991), and Zhou (1998) developed alternative models. Analytical
models for price manipulation through derivatives markets were described in Anderson
and Sundaresan (1984), Cooper and Donaldson (1998), Jarrow (1994), Kumar and Seppi
(1992), Kyle (1984), and Pirrong (1995). Mayhew (2000) comprehensively reviewed these
models. In general, theoretical research revealed that there are many different aspects of
the relation between cash and derivatives markets. Although many models predict that
derivatives should have a stabilizing effect, attaining such a result normally requires
restrictive assumptions. Most empirical evidence suggests that derivatives tend to help
stabilize prices and improve liquidity in the underlying market. However, several papers
conclude that derivatives have had no significant effect on cash markets.5
Theoretical research on emerging derivatives markets developed models to character-
ize the price stabilization function of derivatives markets in emerging market economies.
Several empirical studies examined data from commodity and financial derivatives
markets by comparing underlying market characteristics before and after introduction
dates and by studying the behavior of the underlying market around the expiration dates
of the derivatives contracts. The results, however, are mixed.
Some research results suggested that derivatives markets stabilize or significantly af-
fect the spot price volatility. Dasgupta (1999) studied the commodity futures markets in
India, extending the model developed by Lapan et al. (1991), which analyzed production
and hedging decisions of a competitive firm operating in both futures and options mar-
kets. The extended model includes the possibility of storage of the commodity, therefore
taking inventory decision into account. The author considers that a supplier’s inventory
decision depends on the end of period futures price, the expected production shock, and
the additional costs of carry to store and protect the inventory. Assuming a monopolistic
competitive futures market, it was shown that the futures price elasticity is greater than
or equal to one. Thus, the supplier does not tend to increase profits by increasing price
in the futures market, and therefore, futures price produces stability in both spot and
futures markets. The conclusion also rules out the concern for increased hoarding due to
the existence of the futures market by showing that futures price elasticity of inventory
is inversely related to carrying cost. Any unnecessary hoarding increases carrying costs,
leading to lower responsiveness of inventory to the futures price.
Chiang and Wang (2002) found that the trading of Taiwan Stock Exchange Capitaliza-
tion Weighted Stock Index (TAIEX) futures has a major effect on spot price volatility,
whereas the trading of Morgan Stanley Capital International (MSCI) Taiwan futures
does not. Sequeira et al. (2002) modeled the conditional variances between currency
spot and futures markets for three developed economies (France, Germany, and Japan),
and two emerging economies (Brazil and Mexico). The empirical results suggest that
the conditional variance of the futures returns is statistically significant in explaining the
conditional variance of the spot returns in emerging markets, whereas the opposite is
true in developed markets. These results suggest that exchange rate volatility in emerg-
ing markets is driven by volatility in their respective futures contracts. The currencies of
emerging markets are subject to international influences as well. For developed markets,
 March–April 2008 55

the influence of foreign agents tends to be more controlled, as the results suggest that the
conditional volatility in spot returns drives conditional volatility in futures returns.
Other studies suggest that derivatives markets do not significantly affect the volatility of
the spot price. Spyrou (2005) investigated whether introducing the index futures contract
in August 1999 affected the volatility of the Greek FTSE/ASE-20 index. Employing a
GARCH (1,1) model, the paper examined the nature of the spot volatility before and after
the initiation of futures trading. Empirical findings suggest that futures trading had no
significant effect on the volatility of the underlying spot index. Furthermore, spot index
volatility appeared to have no statistically significant relation with futures trading activity
in the first fourteen months after futures contracts were introduced, from August 1999 to
November 2000. Yo (2001) found that trading in stock index futures did not significantly
change the underlying Hong Kong stock index market. Lee and Oh (1992) examined the
effect of trading in stock index futures on stock return volatility in Australia, Hong Kong,
Japan, and the United Kingdom, reporting no significant volatility increase in Australia
and Hong Kong. Gulen and Mayhew (2000) studied the stock index futures of various
countries, finding that the volatility effects of stock index futures were mixed. With the
introduction of stock index futures, the volatility of the spot index was lower in fifteen
countries, but had no effect in eight other countries.
As for currency futures markets, Jochum and Kodres (1998) examined the influence of
the Mexican peso, the Brazilian real, and the Hungarian forint futures contracts on their
respective spot markets. To account for the characteristics of spot and futures returns, a
Markov switching autoregressive conditional heteroskedasticity (SWARCH) model was
employed to estimate the volatility and showed that futures volatility did not significantly
affect spot volatility.
A related topic is expiration effects—that is, the possibility that index derivatives
cause the underlying stock price to temporarily deviate from the equilibrium as the time
for determining the final settlement price approaches. Expiration effects are summarized
by greater volatilities, price reversals, and abnormal trading volumes. Mayhew (2000)
reviewed the empirical findings in the literature and concluded that, though trading
volumes tend to be unusually high around expiration dates, there is little evidence of
a strong systematic price effect around expiration. Observations from Hong Kong and
Taiwan indicate that different market settlement procedures could have reduced expi-
ration effects. Chow et al. (2003) studied the effect of expiration of Hang Seng Index
derivatives on the underlying spot stock market and found that expiration effects were
less significant than their counterparties in matured markets, possibly because of the dif-
ferent methods Hong Kong used to determine the settlement price. The weighted average
of the index price at five-minute intervals over the entire expiration date was used as the
final settlement price, instead of the price either at the close of the expiration day or at
the opening of the next day. This procedure has the advantage of preventing arbitrageurs
and speculators from manipulating the settlement price, and thus, it could have smoothed
out the settlement price. Examining the expiration effects of five index derivatives traded
on the Taiwan Futures Exchange (TAIFEX), Chou et al. (2006a) showed that the expira-
tion effects in Taiwan were less significant than those in U.S. markets. Once again, the
difference may be due to TAIFEX’s special settlement procedures; the exchange also
uses the average of five-minute price quotations of the TAIEX as its settlement prices.
Using Australian data, Lien and Yang (2003) investigated how expiration effects vary
with the availability and settlement methods of individual share futures contracts. The
authors found that individual share futures contracts dampen the expiration effects on
56 Emerging Markets Finance & Trade

price volatility and the trading volume of individual stocks. Also, stock prices tended
to rise near the expiration dates after physical delivery replaced cash settlement in the
individual share futures contracts.

Prospects
Despite growth over the past years, the notional outstanding amounts in derivatives
markets is fairly small in emerging market economies compared to matured markets.
According to IMF (2002), the most common problems that constrain the development
of local derivatives markets are relatively underdeveloped underlying markets, weak or
inadequate legal and market infrastructures, and restrictions on the use of derivatives.
There is a consensus that the effects of derivatives markets, both positive and nega-
tive, depend on the fiscal and financial fundamentals of emerging market economies.
The problem is not only the use of derivatives per se, but the underlying weaknesses in
domestic and global financial systems, as well as shortcomings in macroeconomic poli-
cies (Khor 2001). For central banks, Morales (2001) discussed the benefits and risks of
cross-border currency and interest rate derivative operations in calm and turbulent periods.
The effect of derivatives on the ability of the emerging market to bear risk and attract
intermediate capital depends on the capacity of the domestic financial system to adapt
to the transformation of financial risks, including the availability of market liquidity and
changes in market conditions. Tables 2 and 3 summarize the expansion of key emerging
derivatives markets and the size and significance of instruments traded.

Financial Market Regulations

It is a major challenge for regulators in emerging market economies to establish pru-
dential regulations. Such regulations should create incentives for market participants to
use derivatives in proper ways and to facilitate capital flows without an increase in risk
to capital. Appropriate regulations include updating accounting rules, capital and risk
management requirements for financial institutions, and more transparent reporting of
derivatives market transactions for both exchange traded and OTC derivatives (Dodd
2000).
As noted in IMF (2003), regulators have to balance the need to allow for more ef-
ficient risk management and market development and the risk of increased exposure to
potential vulnerabilities. The IMF calls for enhanced risk management capabilities of
financial institutions, combined with up-to-date risk-assessment capabilities of regula-
tors. Adopting Basel-style guidelines for capital adequacy would go a long way toward
preventing and mitigating derivatives-related vulnerabilities.
In emerging markets, the accounting rules for derivative instruments are still in their
infancy. Research on accounting rules for derivative instruments has focused on the
Financial Accounting Standards No. 133 in the United States, entitled Accounting for
Derivative Instruments and Hedging Activities (FAS 133). Goone and Kawaller (2000)
compared the implications of FAS 133 on futures versus forwards, discussing the ac-
counting implications of tailing a futures hedge and exploring the preferred hedging
structure in fair value and cash flow hedges. Ronner and Blok (2001) studied the effect
of hedging the global portfolio of cash flows against the reporting currency in light of
FAS 133. The authors recommended global portfolio hedging of foreign currency cash
flows against reporting currency at a consolidated company level.
Table 2. The expansion of key emerging derivatives markets
Key emerging
derivatives markets Time Markets expansion References

Brazil and other January 1986 The Bolsa de Mercadorias & Futuros of Sao Paulo (BM&F) started operation. IMF (2002)
Latin American Dodd (2003)
countries 2001 Almost 98 million contracts were traded in the BM&F with a total open interest of 74
million contracts. The BM&F trades a wide variety of futures, forwards, and options on
interest rates, exchange rates, stock indexes, foreign currency spreads, sovereign debt
instruments, and various metal and agricultural commodities. The BM&F also facilitates
OTC trades. According to International Financial Services, London, BM&F ranked ninth in
terms of the number of contracts traded by the end of 2001.
2000 OTC options on emerging-market debt expanded substantially. The most popular options
were on debt from Argentina, Brazil, Mexico, and Venezuela. IMF estimated in 1999 that
of the $32 billion in debts putable through the end of 2000 for all emerging countries,
$8 billion putable bonds were issued from Brazil. Putable debts were one of the financial
derivatives that could promote crisis-driven capital outflows.
Korea and other May 1996 The stock index future was introduced as the first financial derivative product in an Chou et al. (2006a)
East Asian countries organized exchange in Korea Dodd (2003)
July 1998 The Taiwan Futures Exchange (TAIFEX) was established. Min and Najand
2002 Korean Futures Exchange trades futures and options in interest rates, government (1999)
securities, stock indexes, commodities, and foreign currency. The exchange traded 14.6
million derivatives contracts in 2002 with a notional value of 1,400 trillion won (about
$1.17 trillion). Five financial derivatives products were traded on the TAIFEX with 7.9
million contracts.
2000 IMF estimated in 1999 that of the $32 billion in debts putable through the end of
2000 for all emerging countries, $10.6 billion was in the form of bonds issued from the
East Asian countries, of which $4.0 billion was issued from Korea.
South Africa June 1996 The electronic trading system was introduced in the Johannesburg Stock Exchange (JSE) Beelders and
2001 and South African Futures Exchange are the most liquid financial derivatives markets Massey (2003)
in EMEA. IMF (2002)
March–April 2008
57
 58

Table 3. The size and significance of instruments traded in key emerging derivatives markets
Emerging derivatives
Instruments markets Size and significance References

OTC foreign Five Latin American countries Trading volume totaled $1.739 trillion in 2001. Brazil has the most active BIS Triennial Survey
exchange (Brazil, Chile, Colombia, foreign exchange derivatives markets in Latin America. (2002)
derivatives Mexico, and Peru) IMF (2002b)
Five East Asian countries Trading volume totaled $1,861 billion in 2001 Dodd (2003)
Emerging Markets Finance & Trade

(Indonesia, Korea, Malaysia, The total figure of the five Latin American countries and the five East Asian
Philippines, and Thailand) countries was $3.6 trillion, compared with $2.442 trillion in total foreign
debt of all developing countries.
Hong Kong and Singapore Trading volume totaled $30.255 trillion in 2001. Among emerging markets
in Asia, Singapore has the largest OTC foreign exchange derivatives market,
with average daily turnover of $69.3 billion (April 2001).
South Africa The most liquid OTC forward foreign-exchange market in emerging Europe, BIS Triennial Survey
Middle East, and Africa (EMEA). In April 2001, the average daily turnover (2002)
in the OTC foreign exchange market was $7.9 billion. IMF (2002b)
Exchange-traded Brazil In contrast with many other derivatives markets, a significant part of the BIS Triennial Survey
foreign exchange trading in currency derivatives in Brazil takes place at the BM&F. Notional (2002)
derivatives amounts outstanding as of end-June 2001 was $12.6 billion. IMF (2002b)
OTC interest rate South Africa The most liquid OTC interest rate derivatives market in EMEA. As of BIS Triennial Survey
derivatives end-June 2001, notional amount outstanding was $144.8 billion, compared (2002)
with $214.7 billion total amounts outstanding in all emerging markets. IMF (2002)
Singapore, Hong Kong, The most liquid OTC interest rate derivatives market in Asia. As of end-June
and Taiwan 2001, notional amounts outstanding were $32 billion (Singapore), $19.3
billion (Taiwan), and $4.2 billion (Hong Kong).
Brazil The most liquid OTC interest rate derivatives market in Latin America. As of
end-June 2001, notional amount outstanding was $12.5 billion
Exchange-traded Singapore Singapore Exchange (SGX) is the largest market for exchange-traded interest BIS Triennial Survey
interest rate rate derivatives in terms of outstanding notional, which was $460 billion in (2002)
derivatives end-June 2001 compared with the emerging-markets total of $646 billion. IMF (2002)
Equity-linked Korea, Hong Kong, The Korean equity-index derivatives market has become the second most BIS Triennial Survey
derivatives Taiwan active in the world after that of the United States. The Hong Kong Exchanges (2002)
and Clearing Company (HKE) has been very active in introducing new IMF (2002)
equity-linked derivative products, such as equity-linked notes. TAIFEX also
launched similar instruments to increase retail investor participation. As of
end-June 2001, notional amounts outstanding were $12.7 billion (Korea),
$4 billion (Hong Kong), and $0.4 billion (Taiwan), compared with $50.6
billion total amounts outstanding in all emerging markets.
South Africa In EMEA, South Africa has fairly well-developed equity index futures and
options markets. As of end-June 2001, notional amount outstanding was
$24.4 billion.
Brazil In Latin America, Brazil has the largest equity-linked derivatives market.
As of end-June 2001, notional amount outstanding was $1.8 billion.
March–April 2008
59
60 Emerging Markets Finance & Trade

Under FAS 133, one of the key prerequisites to apply hedge accounting is ex ante
documentation supporting the expectation that the hedge will be highly effective. Many
studies have addressed the measures and implications of hedging effectiveness. Bodurtha
(2005) examined the problem associated with the divergent interest rate risk hedge ef-
fectiveness standards under FAS 133 and IAS 39 and suggested remedies. Kawaller
(2001) analyzed the effect of accounting rules on the market for interest rate swaps. The
paper suggested that to meet hedging effectiveness standards, a hedger should qualify
for the shortcut treatment under FAS 133, which requires that the features of the swap
match precisely that of the debt being hedged. Kawaller and Koch (2000) addressed the
structure of the effectiveness tests, finding that regression results are useful to indicate
hedge effectiveness only if appropriate data are used in the analysis. They also argued
that the correlation coefficient is an insufficient indicator of hedge performance, in that
it relates to an optimal hedge, which may or may not be precisely equal in size to the
hedge that is actually intended.
Some studies analyze the optimal sequencing of development of financial markets (see,
e.g., Allen and Gale 2000; Schinasi and Smith 1998). The general conclusion is that there
are no simple solutions in formulating an optimal development strategy, though a gradual
and complementary approach is always beneficial. Developing well-functioning money
markets appears to be a critical first step in developing corporate bond and derivatives
markets. Money markets are critical to price-fixed income securities and derivatives.
Korea and Thailand provide examples of the difficulties of developing a secondary bond
market and the associated derivatives markets without the support of a well-developed
money market (Cha 2002; IMF 2002).

Derivatives Exchanges
Transactions in derivatives markets are conducted in organized exchanges as well as
OTC. The structure of derivatives exchanges is instrumental to developing derivatives
markets in emerging market economies. Merton and Bodie (1995) conceptually linked
the functions of the financial system to the organizational arrangements that the func-
tions performed, arguing that financial intermediaries differ across borders and that the
institutional structure of the financial system changes over time. The core functions of
derivatives exchanges remain the same across markets, but they are facilitated through
different institutional arrangements; institutional arrangements always follow the func-
tions. Tsetsekos and Varangis (1997) surveyed the structure of derivatives exchanges
in developed and emerging markets, examining issues such as products and contract
classification, sequencing and timing of contract introduction, and exchange structure
in terms of life span, ownership, membership, clearinghouse arrangements, settlement
procedures, and economic and capital market conditions for the development of deriva-
tive exchanges. Empirical evidence supported the proposition developed by Merton and
Bodie (1995), and elucidated the extent to which the functional perspective by Merton
and Bodie (1995) has validity. The study leads to several useful lessons for developing
derivatives exchanges in emerging market economies. Clearing is an extremely important
function; the process of introducing successful derivative products could be lengthy; and
partnerships and joint ventures between existing exchanges and newly emerged exchanges
can be mutually beneficial.
Several papers studied the trading mechanisms of derivative exchanges in emerging
markets. Chou et al. (2006b) examined margins and price limits in Taiwan’s stock index
 March–April 2008 61

futures markets and constructed the cost minimization combination of spot limits, futures
limits, and margins for stock and index futures. The authors studied daily closing prices
from July 21, 1998, to March 5, 2001, for the Taiwan Stock Exchange (TAIEX) and its
futures contracts. The empirical results showed that when the index level is less than
7,000, the cost minimization combination of spot limits, futures limits, and margins is
7 percent, 6 percent, and 6 percent, respectively. The efficient combination consists of a
margin of 6.5 percent, spot price limits of 5 percent, and futures price limits of 6 percent
when the index level ranges from 7,000 to 9,000. Cheng and Kang (2007) studied the
effects of alternative price formation processes on the Taiwan stock index futures market.
The authors compared the performance of call auction and continuous auction, using
intraday data from February 21, 2002, to December 31, 2002, covering the periods before
and after the change of price formation processes in July 2002. The results indicated that
the market is more liquid, with slightly lower volatility and improved market efficiency
under continuous auction. The authors concluded that continuous auction provides a better
trading environment for futures contracts than does call auction for an emerging futures
market such as that of Taiwan. Chen and Kao (2006) analyzed the benefits of excluding
institutional investors from Taiwan’s fixed price initial public offerings (IPOs): Excluding
institutional investors from subscription alleviates the winner’s curse. As a result, IPO
underpricing is reduced by at least 4 percent.

Summary of Findings
Both commodity and financial derivatives markets have grown in emerging market
economies over the past few years, though the sizes of the markets are relatively small
compared to those of matured economies. Many papers, both theoretical and empirical,
address the roles of derivatives markets in emerging market economies. The studies reveal
that commodity derivatives markets offer a more effective and welfare-improving method
to deal with price volatility. Financial derivatives markets have helped to support capital
inflows into emerging market economies. On the other hand, using financial derivatives
has had negative effects, leading to exacerbated volatility and accelerated capital outflow.
There is a consensus that the derivatives are seldom the cause of the crisis, but they could
amplify the negative effects of the crisis and accelerate contagion. The underlying reasons
for the negative effects are associated with the leverage nature of derivatives transactions,
nontransparent reporting of transaction risks, and unsophisticated or insufficient risk
management controls in financial institutions, as well as weak prudential supervision.
As for the function of derivatives markets, academic research infers how emerging
derivatives markets fulfill their functions of risk reduction and redistribution and price
discovery and stabilization, compared to what has occurred in mature markets. The studies
support the hedging role of emerging derivatives markets. Research on optimal hedging
strategies reveals the effects of emerging market factors on the formulation and imple-
mentation of the optimal hedging ratio. Such factors could include, among others, uncer-
tainty of the commodity production volume, existence of currency risk, and management
of multiple risks. Empirical studies on the futures markets in a few emerging countries
suggest a price discovery function of these markets. On the other hand, research showed
mixed results on the price-stabilization function of emerging derivatives markets.
Recent studies stress that the constructive development of derivatives markets in
emerging market economies needs to be supported by sound macroeconomic fundamentals
and updated financial policies and regulations. There is no uniform optimal development
62 Emerging Markets Finance & Trade

strategy that countries can adopt to sequence or structure their markets; gradual develop-
ment schemes accounting for dynamics in different markets are encouraged.

Notes
1. See, e.g., Lence and Hayes (1994a; 1994b) and Lien and Tse (2000) on the empirical
implementation of the minimum variance hedge strategy, and Cheung et al. (1990), Kolb and
Okunev (1992), Lien and Luo (1993), and Shalit (1995) on empirical applications of the extended
mean Gini approach.
2. The hedging role of options is analyzed in Agmon and Eldor (1985), Eaker and Grant
(1985), Feiger and Jacquillat (1979), Giddy (1985), Moschini and Lapan (1995), Sakong et al.
(1993), and Wong (2003).
3. For empirical studies on hedging with multiple risks, see Meulbroek (2002), Mun and
Morgan (2003), and Schrand and Unal (1998).
4. See, e.g., Herbst et al. (1987), Kawaller et al. (1987), and Stoll and Whaley (1990) for the
U.S. markets; Iihara et al. (1996) for the Japanese market; and Grunbichler et al. (1994) for the
German market.
5. The voluminous literature includes, among others, Antoniou and Foster (1992), Kocagil
(1997), Morgan (1999), Netz (1995), and Weaver and Banerjee (1990) on commodity futures;
Edwards (1988), Ely (1991), Hegde (1994), and Simpson and Ireland (1985) on fixed income
futures; Antoniou and Holmes (1995), Chang et al. (1999), Gulen and Mayhew (2000), Kumar et
al. (1995), and Salih and Kurtas (1999) on stock index futures; and Adrangi and Chatrath (1998),
Bahr and Malliaris (1998), Chatrath et al. (1996), and Clifton (1985) on currency futures.

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