Does the Introduction of Futures on Emerging Marke

IMFStaffPapersVol.45,No.3(September1998)©1998InternationalMonetaryFund486DoestheIntroductionofFuturesonEmergingMarketCurrenciesDestabilizetheUnderlyingCurrencies?CHRISTIANJOCHUMandLAURAKODRES*Recentinterestinfuturescontractsonemergingmarketcurrencieshasraisedconcernsamongsomecentralbankauthoritiesabouttheirabilitytomaintainstablecurrencies.Thispaperpresentsempiricalresultsexamin-ingtheinfluenceoftheMexicanpeso,theBrazilianreal,andtheHungarianforintfuturescontractsontherespectivespotmarkets.Whilemeasuresoflineardependenceandfeedbackindicatestrongconnectionsbetweentherespectivemarkets,futuresvolatilitydoesnotsignificantlyexplainspotmarketvolatility,nordoesitincreaseafterfuturesintroductions.Toaccountforthecharacteristicsofthespotandfuturesreturns,aSWARCHmodelisemployedtoestimatevolatility.[JELC22,G15]INCREASEDVOLUMEandvolatilityofcapitalflowstoemergingmarketcountrieshassparkedinterestinderivativecontractsonemergingmarketcurrencies.Higheconomicgrowthandcapitalaccountliberalizationhaveincreasedcurrencyexposuresofbothdomesticentitiesandtheirforeigncounterparts.Thedemandforinstrumentstomanagethecurrencyriskasso-ciatedwithportfolioinvestment,aswellasforeigndirectinvestment,isalso*ThispaperwaspreparedwhileChristianJochumwasvisitingtheIMF.HeisaPh.D.studentattheUniversityofSt.GallenandholdsanM.Sc.fromtheUniversityofWarwick.LauraKodresholdsaPh.D.fromNorthwesternUniversityandisanEconomistintheIMF’sResearchDepartment.TheauthorsaregratefultoCarloCottarelli,RobertFlood,GraemeJustice,CharlesKramer,RickyLam,DavidNg,LorenzoPerez,PatriciaReynolds,S.HosseinSamiei,GarrySchinasi,GabrielSensenbrenner,andPhilipYoungforhelpfulcommentsanddiscussionduringthepreparationofthepaper,toDarvasZsolt,oftheHungarianNationalBankfortheprovisionoftheHungariandata,andtotheMalaysianauthoritiesfortheinitialprompttoundertakethestudy.TheyarefurthergratefultoJamesHamilton.expandingquicklyinthesemarketsastheybecomemoreglobal.Moreover,currencyhedgingproductshaveemergedascountrieshavemovedfrommanagedfloatregimestomorefullyfloatingones.Currencyfutures,sincetheyaretradedonorganizedexchanges,conferbenefitsfromconcentratingorderflowandprovidingatransparentvenueforpricediscovery,whileover-the-counterforwardcontractsrelyonbilateralnegotiationsatoftenunpub-lishedprices.However,despitethegrowingdemandforsuchproducts,cur-rencyfuturescontractsarestillinearlystagesofdevelopment.Whilefuturesexchanges,bothabroadanddomestic,arekeentointro-ducefuturesonemergingmarketcurrencies,theauthoritiesinmanyofthesecountriesarewaryoftheirdevelopment.AspokespersonfromtheMonetaryAuthorityofSingapore(MAS)describedacommonlyheldcon-cern:“[The]MASisconcernedaboutanytradingactivityintheSingaporedollar,whichhasthepossibilityofbeingdestabilizingtothemarket.”1Anumberofspeculativeattackshavebeenwagedagainstemergingmarketcurrenciesoflate,makingofficialsmoresensitiveabouttheircurrencies’volatilityandtheirabilitytostabilizeexchangeratesduringacurrencycri-sisinthepresenceofafuturesmarket.Theimplicitviewofmanyauthori-tiesisthatfuturesmarketsharborspeculatorswhocanemployextensiveleveragetomovetheunderlyingmarketinundesireddirections.Althoughfuturesonemergingmarketcurrencieswereintroducedrel-ativelyrecently,theconcernthatderivativemarketsdestabilizetheunderlyinginstrumentisalong-standingpolicyissue.Theoreticalworkontheimpactoffuturesandoptionsontheunderlyinginstrumenthasyieldedmixedconclusions.Twocharacteristicsoffuturescontracts—theirminimalmarginrequirementsandthelowtransactionscostsrelativetoover-the-countermarkets—driveboththepositiveandnegativeresultsfoundinthetheoreticalliterature.Thesetwocharacteristicsoffuturescontractsareinextricablylinkedtotheexistenceofaclearinghouse,whichtakestheothersideofeverytrade,makingacreditassessmentofone’scounterpartyunnecessary.Creditrisksarefurthermitigatedbydailymarkingtomarketofallfuturespositionswithgainsandlossespaidbyeachparticipanttotheclearinghousebytheendofthetradingsession.Initialmargin,typicallylessthan5percentofthenotionalvalueofacon-tract,isplacedwiththeclearinghousetoserveasabufferorperformancebond,whilethedailymaintenancemarginlimitsthescopeoflargelosses.Moreover,futurescontractsarestandardized,utilizingthesamedeliverydatesandthesamenominalamountofcurrencyunitstobetraded.Hence,tradersneedonlyestablishthenumberofcontractsandtheirprice.ContractstandardizationandclearinghousefacilitiesmeanthatpriceINTRODUCTIONOFFUTURESONEMERGINGMARKETCURRENCIES4871InternationalSecuritiesRegulationReport(1997),p.3.discoverycanproceedrapidlyandtransactioncostsforparticipantsarerelativelylow.2Thetwostrainsofthetheoreticalliteratureusethesefuturesmarketchar-acteristicstoarguethat,ononehand,sinceminimalmarginrequirementsandlowtransactioncostspermitinvestorstoholdlarge,highlyleveragedpositionsandlowerthebarriertoentrytothemarket,futuresmarketsattractuninformed,oratleastdifferentiallyinformed,traderswhocandestabilizetheunderlyingmarket.3AsdescribedbyShastri,Sultan,andTandon(1996),theadverseeffectsoccurwhenthereisamigrationofuninformedtraderstothefuturesmarketfromtheunderlyingmark