1. FINANCIAL INNOVATION: GROWTH AND NEW PRODUCTS DERECHO & ECONOMÍA Dr. HERNÁN SABAU MAY 2001 DERIVATIVES AND RISK MANAGEMENT IN MEXICO

2. Fixed income securities Interest rate Foreign exchange Currencies Equity Indices and individual stocks Credit Default risk Innovations in different markets DERECHO & ECONOMÍA

3. Fixed income Petrobonos (1977) OTC Senior / Junior structures (1993) FX Coberturas cambiarias (1987) Equity Warrants market (1992) IPC, guaranteed returns, american call spreads OTC issues Nafta warrant (1993) MexDer Futures on individual stocks (1999) Credit (?) The Mexican Derivatives Market: past innovations in different markets DERECHO & ECONOMÍA

4. Trading Volume has grown very slowly Underlying markets: depth and liquidity 1994 / 1995 crisis: effects on credit and the financial system Regulatory issues Excess controls through early and mid 90’s Capital requirements after crisis Risk management Tax implications Risk culture The Mexican Derivatives Market has not grown to a mature market DERECHO & ECONOMÍA

5. Up to 1999 longest rate was for 91 days Development of a long term interest curve: Decreasing inflation and stability Bank disintermediation: increasing market share of Government debt Introduction of M2 – M5 bonds: fixed income 2-5 year bonds with fixed rate Institutional investors: Afores, Life Annuities, Insurance Companies The Mexican Derivatives Market: recent developments favoring innovation in the Fixed income and FX markets DERECHO & ECONOMÍA

6. Recent developments favoring derivatives innovation: bank disintermediation DERECHO & ECONOMÍA 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 98AJO99AJO00AJO Checking accounts + current deposits Rest of bank securities deposits Government securities-held by residents Private securities- held by residents Annual Real Growth Market Share

7. Recent developments favoring derivatives innovation: Government debt with fixed rates and 2 to 5 years maturity DERECHO & ECONOMÍA Government Securities Structure (Thousand dollars)

8. Recent developments favoring derivatives innovation: Institutional Investors DERECHO & ECONOMÍA Siefores Mutual Funds Insurance Companies and Life Annuities (Reserves) All figures in million dollars

9. Recent developments favoring derivatives innovation: 5 year interest rate curve DERECHO & ECONOMÍA

10. Recent developments favoring derivatives innovation: 5 year interest rate curve DERECHO & ECONOMÍA

11. Development of more depth and liquid markets Deregulation: easier access to markets Capital requirements and risk control Market makers Since october 2000, 5 institutions Only Fixed rate Government securities More competitive picture in equity trading Opening of listed futures market and clearing corporation The Mexican Derivatives Market: recent developments favoring innovation in the Fixed income and FX markets DERECHO & ECONOMÍA

12. Recent developments favoring derivatives innovation: more liquidity DERECHO & ECONOMÍA Liquidity (Daily turn over/outstanding) Fixed Rate Securities CETES17.77% BONO M3139.55% BONO M52.03% Floating Rate Securities BONDE 280.42% BONDE 910.56% BONDES 1820.95% BONDES T0.000% Inflation Link Securities UDIBONOS 30.002% UDIBONOS 50.003% UDIBONOS 100.000% IPAB Securities IPAB0.002% Central Bank BREMS0.002%

13. Recent developments favoring derivatives innovation: more competitive equity market DERECHO & ECONOMÍA Otras 16% Vafin 3% Goldman Sachs 5% Bancomer 4% Inbursa 6% Probursa 7% Inverlat 7% Banorte 7% Santander 9% Vector 9% GBM 8% Merril Lynch 9% Accival 10%

14. Fixed income securities Interest rate swaps (28d vs up to 5 yrs) Caps and floors Foreign exchange Currency swaps Options, futures and forwards Equity (?) Credit (?) Asigna: absortion of counterparty risk Problem: mostly interbank, lack of corporate risk policy Scene for derivative innovations which are on the way in different markets DERECHO & ECONOMÍA