Report on derivatives markets: stabilizing or speculative impact on Chile and a comparison with Brazil
Randall Dodd and Stephany Griffith-Jones
Derivatives markets in Chile and Brazil play a large and growing role in their financial markets and overall economic activity. Of special importance is Chile's over-the-counter market in foreign exchange derivatives which has become an established market with dealers, high liquidity and low bid-ask spreads. These derivatives markets have helped many firms lower their risks and lower their borrowing costs. At the same time, they pose new challenges to the stability of Chile's economy. This report focuses on Chile, and to a lesser extent on Brazil, to provide an analytical description of the growth of derivatives markets and an economic analysis of their role in the economy. The first part includes a discussion of the various derivatives instruments, the different market participants and the manner in which prices are determined in these markets. Also included in this descriptive analysis is a discussion of Chile's regulatory framework for derivatives and how they have shaped the growth and stability of the markets. The second part of the report includes an economic analysis of what derivatives markets mean for the cost and risk of foreign borrowing, the stability of international capital flows, pro-cyclical linkages to exchange rate movements, the use of derivatives in certain hedge fund investment strategies, and the potential risks to the stability of Chile's financial markets. Using a unique data base of derivatives' daily open position for Chile, provided by the Central Bank, we analyze their impact on the exchange rate during particular periods. It also includes a discussion of derivatives' use in speculative flows between Chile and Brazil.
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