This paper analyzes how financial risks can be managed in companies, as well as the characteristics and classification of derivative instruments, including futures, options, Fras and swaps or swap operations, in addition to expose the advantages offered by these products, with the aim of highlighting how, an adequate use of them can not only help to meet profitability objectives, but also to clearly reduce risk positions and achieve greater business efficiency.
In the investigation an exhaustive analysis of all the financial derivatives was carried out, their forms of use, advantages, disadvantages; its possible application in the Cuban economy. It is intended to be a spearhead of a topic that has been little discussed by Cuban specialists.
Development
If a reason for financial engineering arises, it would be the lack of stability: lack of stability in the exchange system, in interest rates, in the markets, in the creditworthiness of the countries, and in short, a greater risk in the set of financial operations. Many companies have realized that this instability can cause them difficulties in achieving the expected cash flows, and in some cases, leading to bankruptcy or hostile takeovers.
All this has created the demand for financial instruments that manage this type of risk.
Financial markets are made up of three fundamental markets; debt markets, (which in turn include interbank, currency, money, and fixed income markets), equity markets, and derivatives markets.
The boom in derivatives markets in recent years has been spectacular, basically caused by their use to hedge risks. And precisely, the ability to separate risk from fluctuations in the prices of a company's underlying physical operations and manage them separately, through the use of derivatives, is the greatest of the financial innovations of the 1980s. But it is that, in turn, as products are created for this purpose, their application is appreciated, not only in the coverage of risks, but also to cover other needs of the company.
The derivatives market.
The securities that are traded in the derivatives markets are “derived”, either from raw materials, or from fixed-income, variable-income, or indices made up of some of those securities or raw materials, to which they are called underlying. They are based on classic or conventional assets, but with some modifications in their operations. For example, in spot or spot operations, the exchange of assets, in exchange for the agreed price, takes place at the same time the contract is formalized. In term operations, pioneers in derivative operations, the execution of the contract is not carried out at the time of its formalization, but at a later time or expiration date. On the current or formalization date, the contracting parties agree to all the terms of the contract,including the forward price or forward price of the transaction.
Thus, the forward rates or “forward rates” will be the price that the market establishes for a financial instrument that is negotiated today but whose transaction will take place at a later date. These operations can be carried out in organized markets, originating financial futures or in unorganized or OTC markets, such as FRAs operations. Otherwise, if what is considered is the possibility or not of the delivery of the contracted asset, at the choice of one of the contracting parties, the options originate. Another advantage of derivative operations, unlike classic financial assets, is the non-necessity for the monetary flow to occur for the total amount of the operation, thus allowing risk coverage without the possibility of loss. of the total principal in the case of non-payment.
Within derivative markets, it is possible to distinguish between derivative instruments that are traded in organized official markets, where there are a series of characteristics such as the typification or normalization of contracts, the assurance of settlements through the clearing house, transparency of the quotes, the guarantee regime, the gradual and final settlement of the differences, etc.; and others that do not comply with these characteristics, and that are traded in unorganized or OTC (Over The Counter) markets, where the two contracting parties set in each case the contractual terms of the operations agreed between them.
At the same time, within the unorganized or OTC derivatives markets, forward transactions, financial swap or swaps operations and OTC options are traded, which also include caps, floor, collar and swaptions, while in the Organized derivatives markets basically trade futures and options. The main application of all these instruments is the coverage of financial and market risks, to which economic agents are subject, mainly that caused by changes in interest rates, exchange rates, prices of raw materials and stock markets..
Main Operations of the derivatives market.
Derivatives have common features, worldwide, which are summarized.
- There are forward operations. These are operations in which, between the moment of contracting and the liquidation, a period of time long enough to make possible and convenient the existence of a secondary market elapses. There are "tailor-made" operations. This feature is equivalent to the contracting parties freely choosing the selected underlying asset, its quantity, its price and the expiration date. This level of specification allows, whenever a counterpart is found, an extremely exact adaptation to the needs of each operator, guaranteeing a sale price for the desired instrument, in the precise quantity and exactly on the future date sought. settlement. With the aforementioned characteristics,the two derivative transactions have sufficient levels of settlement risk to require careful selection of the other participant in the transaction. Operations with strong leverage. This feature is evident considering that both operations offer the possibility of theoretically unlimited benefits without any initial outlay, in the case of forward purchases, or paying a relatively small premium, in the case of the purchase of options. indicated in the previous number, they can be relatively expensive operations, if the following costs are taken into account, not always explicit: search, since there is no organized market; liquidity, due to the absence of a secondary market; and those attributable to the aforementioned risks.
The main utilization possibilities presented by organized futures and options markets are already present in "custom" forward transactions.
The first function of derivative instruments is to provide a hedging mechanism against market risk, that is, against the possibility that the market price of a financial instrument may vary causing losses or lower profits. Regarding the causes of this variation, significant for the topic discussed, we can speak of three variants of market risk.
The first of these, interest rate risk, measures the possible losses, or lower benefits, that a variation in the level or structure of interest rates may generate. The second type of market risk is exchange rate risk, which measures the losses, or lower profits, that may cause variations in the exchange rate of the national currency against the currency in which the different assets are denominated and Passives. In this case, the position against a currency is considered long when, for a given date, the amount of the assets exceeds that of the liabilities, in both cases denominated in it, and short, otherwise.
In the face of all these forms of market risk, the hedging procedure is the same, since it consists of carrying out operations that contribute to reducing risk exposure, that is, forward purchases or purchase or issuance of options, so that the Previous open positions are closed in whole or in part, that is, the hedging procedure consists of ensuring today the price of the financial operations, active or passive, that are going to have to be carried out in the future. Therefore, the perfection of the hedge will be the greater the more exactly they coincide for the open position and for the hedging operation:
a) the amounts, b) the dates or deadlines, and
c) the variability of the price of the financial instrument in which the open position is recorded and of the underlying asset in the hedging operation, if they are not the same.
Therefore, it is clear that hedging operations are driven by the desire to reduce or eliminate the risk derived from the fluctuation of the price of the underlying asset.
Hedging is more effective the more correlated are the price changes of the hedged assets and the price changes of futures. This is why the loss in one market is partially or totally compensated by the profit in the other market, provided that opposite positions have been taken.
The brief description of the coverage mechanisms highlights two important aspects. The first is that the need to hedge does not derive from the volume of operations in the markets, but especially from the volume and structure of the portfolios and the way of financing them. The second is that, provided that the magnitude and causes of the price variability are similar, that is, provided that their respective markets are sufficiently integrated, hedging operations based on an underlying asset can be carried out to reduce the risks derived from open positions. in other different instruments. This explains the possibility of using notional assets, which do not exist in reality, or baskets of assets, in hedging operations as underlying assets.
The Futures.
A futures contract is an agreement, traded on an organized exchange or market, which forces contracting parties to buy or sell a number of goods or securities (underlying asset) at a future date (exercise date), but with a price established in advance (exercise price).
Whoever buys futures contracts, adopts a "long" position, so they have the right to receive the underlying asset under negotiation on the expiration date of the contract. Likewise, whoever sells contracts acquires a “short” position in the market, so upon reaching the expiration date of the contract, he must deliver the corresponding underlying asset, receiving in exchange the corresponding amount, agreed on the trading date of the futures contract..
Apart from the fact that a futures contract can be purchased with the intention of maintaining the commitment until the expiration date, proceeding to the receipt of the corresponding asset, it can also be used as a reference instrument in speculative or hedging operations, One way to do this is to keep the position open until the expiration date; if deemed appropriate, the position can be closed with an operation of a sign contrary to the one initially carried out. When you have a buyer position, you can close it without waiting for the expiration date simply by selling the number of buyer contracts you have; Conversely, someone with a selling position can close it early by going to the market and buying the required number of futures contracts to be offset.
The futures contract, whose price is formed in close relationship with the reference or underlying asset, is quoted on the market through the trading process, and can be bought or sold at any time during the trading session, allowing the active Participation of operators who usually carry out speculative operations in order to generate profits, but who provide the liquidity necessary for those who wish to carry out hedging operations to find a counterpart. For more than two centuries, futures contracts have been negotiated on raw materials, precious metals, agricultural products and various merchandise, but for financial products they have been negotiated for two decades, with futures on interest rates in the short, medium and long term,currency futures and stock index futures. There are different types of products determined with the futures, among which those used mainly on Stock Indices and on Stocks stand out.
An option is a contract between two parties by which one of them acquires over the other the right, but not the obligation, to buy or sell a certain quantity of an asset at a certain price and at a future time. Options traded are usually on futures contracts or on shares and generally have the characteristic of being of the American type, that is, they can be exercised at any time until the expiration date, using the closing price of the underlying, future or action, to carry out the settlement of the options.
Like futures contracts, options are traded on interest rates, currencies and stock indices, but additionally, stock options and options on futures contracts are traded.
There are two basic types of options:
- Purchase option contract (Call). Put option contract (Put).
Just as in futures the existence of two elementary strategies is observed, which are the purchase and sale of contracts, in options there are four elementary strategies, which are the following:
- Purchase of purchase option (long call). Sale of purchase option (short call). Purchase of put option (long Put). Sale of put option (short Put).
The symmetry of rights and obligations that exists in futures contracts, where the two parties are forced to make the sale when the expiration date arrives, is broken in the options since one of the parties (the buyer of the option) has the right, but not the obligation to buy (Call) or sell (put), while the seller of the option will only have the obligation to sell (Call) or to buy (Put). Said difference of rights and obligations generates the existence of the premium, which is the amount that the buyer of the option will pay to the seller of the option.
Exercising a Call option generates a buying position of the underlying for the holder of the buying option and a selling position for the seller of the option. Exercising a put option, on the other hand, generates a selling position of the underlying for the holder of the put and a buying position for the seller of the put. Therefore, for each option exercised, an open position is generated in the underlying.
Depending on the Strike Price and the Price of the Underlying (or the price of the shares) at any time, we can classify the Options in: “in the money” (in English, “in-The-Money”), “in the money ”(“ At-The-money ”) or“ out of the money ”(“ out-Of.-The-Money ”). Therefore, an Option is said to be “in the money” if, exercising it immediately, we obtain profit. An Option is said to be "out of the money" if, exercising it immediately, we do not make a profit. An Option is said to be "in the money" when it is at the boundary of profit and loss.
In the case of a call option it is “in The money” if the strike price is below the price of the underlying, while a put option is “in the money” when the strike price is higher than the price of the underlying; of course one option is "out of. The money ”when the situation contrary to that described above occurs for the“ in The money ”options, with the exception of the options that are“ at The money ”which only happens when the strike price and the underlying price coincide.
The cousin.
The Premium is the amount of money that the buyer of an Option pays to acquire the right to buy (Call Option) or to sell (Put Option). In turn, this same amount of money (Premium) is what the seller of the Option receives, forcing him, in case of exercise, to sell (in the case of a Call Option) or buy (for a Put Option) the shares at the fixed price (Exercise Price).
What is traded in the Options Market is the Premium, in which buyers and sellers establish different prices for the demand and supply of the Options, based on their expectations regarding the evolution of the share price. In this way, when the demand and supply price coincide, a "crossover" occurs, that is, an operation is performed. So, just like in any other market, it's about buying low and selling high. There is a wide variety of Strike Prices and Maturities available to potential buyers and sellers for them to negotiate different Premiums. The Option Premium or price consists of two components: its intrinsic value and its extrinsic or temporary value.
The intrinsic value of an Option is defined as the value that an Option would have if it were exercised immediately, that is, it is the difference between the Price of the Underlying and the Exercise Price of the Option, therefore we can specify that it is the value it has the Option by itself.
The part of the Premium that exceeds its intrinsic value is defined as extrinsic or temporary value.
A significant element is knowing how the Premium is determined, for this the following factors must be taken into account:
- Price of the share today (Price of the Underlying Asset) Price at which we want to assure the price (Exercise Price) Time during which we want to assure that price (Time to Maturity) Dividends paid by the share during that period (Dividends) Interest rate risk-free that exists at that time (Interest Rate) The investor's expectations about how much and how often the price of the underlying will change in the established period (Volatility).
Fras contracts.
Fras contracts (Forward Rate Agreement) were created to guarantee the interest rate in investment and financing operations, replacing forward-forward deposits.
A Fras is a forward contract on interest rates through which two parties agree on the interest rate of a theoretical or notional deposit, for a term and for a specified amount, to be made at a stipulated future date. They allow to eliminate the risk of fluctuations in the interest rate during said period.
The fundamental application of this financial instrument, and which has produced its spectacular growth, is the setting of the amount of interest on a loan / loan or an investment, for a certain future period, without at any time the parties exchanging the principal (contract nominal), since it is theoretical and does not exist.
Operational mechanics of FRAS operations.
In operations with Fras, the only thing that is settled are interest differentials between the current rate in the interbank market (EURIBOR, LIBOR) and the stipulated rate. For this reason, the FRAS contract is not a financing instrument, but rather a hedging instrument, offering those involved the elimination of the risk derived from possible fluctuations in interest rates.
Contracting parties are called buyer and seller. The buyer of the FRAS is the contracting party that wants to protect itself from an interest rate rise, acting as a hypothetical future borrower, while the seller of a FRAS is the contracting party that wants to protect itself against a decrease in the interest rate, acting as a future hypothetical lender. In this way, if, on the settlement date, the reference rate is higher than the guaranteed rate, the seller must pay the difference to the buyer and vice versa. In practice, only one of the parties is the one that wishes to insure a type, the other counterparty being a financial entity that acts as counterparty.
The most frequent contracts are: 1 month against 3 or 6 months, 3 against 6 or 12, 6 against 9 or 12 and 9 against 12. For longer terms they do not have liquidity, so their usefulness is for the management of rates of short-term interest. As an example of this operation we can put the case of a company that wants to protect itself, within three months, from a rate hike for a period of six months for an amount of 100,000 Euros. For this, it would buy a FRAS3 / 9 for a nominal value of 100,000 Euros.
If the agreed rate is the time of signing is 5% on an annual basis, the following situations could occur at the start of the contract when settlement for differences is made:
- That the market interest rate is higher than 5%. In this case, the selling entity of the FRAS would be the one who should assume the difference, since the cost of the deposit will be greater than the guaranteed one. That the market rate is less than 5%. In this case, the buyer would have to assume the difference up to the contractual rate (5%), since the cost of the deposit will be less than the guaranteed one.
In both cases, the buyer of the FRAS contract ensures that the interest rate to be paid on a three-month deposit of 100,000 euros to be obtained within three months will be 5%, once the definition and classification of the swaps of interest rates (IRS).
Financial swap operations or swaps are contracts in which two economic agents agree to exchange monetary flows, expressed in one or more currencies, calculated on different types or benchmarks that can be fixed or variable, during a certain period of time. Within these structures we can distinguish between interest rate, currency, commodity or raw material and stock swaps. However, since the most widely used are interest rates, in this paper we will only focus on analyzing the characteristics and applications of the latter.
An interest rate swap, or interest swap, is a contract in which two parties agree, for a set period of time, to a mutual exchange of periodic interest payments nominated in the same currency and calculated on the same principal but with different reference types. In the most common case, one of the parties pays the interest at a variable rate based on the EURIBOR or LIBOR, while the other party does so at a fixed or variable rate, but in this case, referenced to a different basis.
There are two basic or generic types of interest rate swaps, the so-called:
- Fixed vs. variable swaps or “swap coupon”, in which one flow is exchanged at a fixed rate in exchange for another at a variable rate. Variable vs. variable swaps or “basis swaps”, in which two flows of interest are calculated at the rate variable, such as the 3-month EURIBOR against the 6-month EURIBOR, 3-month EURIBOR against the 3-month LIBOR, etc.
Non-basic modalities originate from variations on the characteristics of generic swaps, among which are the swaps with non-constant principal, swaps with deferred start, swap with a fixed rate that varies throughout the operation, etc. The main applications of these instruments, like any other derivative transaction, are risk coverage, speculation or arbitrage.
Derivative instruments in Cuba. Advantages of its use.
Before delving into the advantages that the use of derivative instruments would have in Cuba, it is necessary to make an assessment of the conditions that favor their use. Until the beginning of the 1990s, financial risk was hardly mentioned in the context of Cuban economic-financial relations. After Marx referred indirectly to it, in addressing the emergence of loan capital as a decoupled part of social capital and Lenin contacted the birth of capital and the financial oligarchy, as a consequence of the merger of monopoly banking with industrial capital, the Socialist political economy virtually banished the term, assuming it alien to the planned nature of production theoretically at odds with spontaneity.
In the Cuban case, the insertion of the island in the socialist field and the consolidation of the exchange with those nations reaffirmed that criterion, endorsing the country's economic structures.
The modifications introduced in the national economy and the reorientation of its links with the exterior motivated by known events, put an end to the myth of certainty that has led to consider risk as a basic element within the Cuban economy, which is therefore necessary manage. If asked to synthesize the elements that underlie the objective nature of risk in the current conditions of development of the Cuban economy, three fundamental aspects would be mentioned:
- The conditions that allowed the planning, with a minimum dose of uncertainty, of most of the economic relations with the exterior disappeared. The economic and financial links with the capitalist world are increased, through the participation of capital that enables access to new technologies. and the increase in trade with a growing group of countries that propose these rules of the game. It increases the autonomy of the business system and financial institutions in the context of the internal economy, which presupposes the need to hedge against the risk of breach of obligations. contractual.
If it were said in a few words, in the new conditions of the Cuban economy it is essential to achieve an efficiency that gradually makes its productions internationally competitive. There is no doubt that financial engineering techniques through derivative instruments for risk coverage have proven their effectiveness when it comes to achieving the optimal exploitation of the scarce resources available.
If the elements set forth in this work are taken into account, it will be understood that, far from harming, the study of the operation of derivative instruments and the use of the techniques derived from them would contribute to achieving greater efficiency for companies. Cubans that carry out operations abroad, since it would allow them to cover the environmental risk that undoubtedly prevails in today's globalized world.
There is no doubt that the derivatives market exposes the exploitative essence of capitalist society, but its techniques can help socialist companies to be efficient.
We will analyze its characteristics, potentials and advantages, in order to understand its technical essence so that it helps us achieve the optimal result from an economic point of view. To understand the essence of phenomena, let us continue to resort to Marxist doctrine. In short, let's not ask the elm for pears, but let's take advantage of its shade.
Advantages of derivative instruments.
The main advantages of trading with derivative instruments are:
- They allow investors who wish to do so to cover themselves with market variables such as the exchange rate, interest rate, and asset prices. They allow organizations to make a better estimate of results, since when dealing with derivative instruments variables are known of the market that were previously unknown, with which it is possible to obtain estimates of flows with greater accuracy. The operational costs of coverage are lower than those of a traditional coverage. They present a possibility of obtaining results, that is, with a small investment you can making big profits, as long as market expectations are met, otherwise big losses can also occur.
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