2000. Lessons in structuring derivatives exchange

The global deregulation of financial markets has created new investment opportunities, which in turn require the development of new instruments to deed with the increased risks. Institutional investors who are actively engaged in industrial and emerging markets need to hedge their risks from these cross-border transactions. Agents in liberalized market economies who are exposed to volatile commodity price and interest rate changes require appropriate hedging products to deal with them. And the economic expansion in emerg-ing economies demands that corporations find better ways to manage financial and com-modity risks. The instruments that allow market participants to manage risk are known as derivatives because they represent contracts whose payoff at expiration is determined by the price of the underlying asset—a currency, an interest rate, a commodity, or a stock. Derivatives are traded in organized exchanges or over the counter by derivatives dealers. Since the mid-1980s the number of derivatives exchanges operating in both industrial and emerging-market economies has increased substantially. What benefits do these ex-changes provide to investors and to the home country? Are they a good idea? Emerging markets can capture important benefits, including the ability to transfer risks, enhance public information, and lower transaction costs, but the success of a derivatives exchange depends on the soundness of the foundations on which it is built, the structure that is adopted, and the products that are traded Since the mid-1970s interest and exchange rates and prices of primary commodities have fluctuated widely. Major exchange rates—both nominal and real—have varied since the move to the floating-rate system in 1973. Commodity prices have been even more volatile, with large shirts in supply and demand for individual commodi-ties. Unanticipated changes in exchange rates, interest rates, and commodity prices introduce risks that cannot be ignored. Financial price risk has important implications for both the private and public sectors. Price fluctuations not only affect business profits but can also affect a firm'