Forwards
This type of derivative instrument is the oldest, this type of contract is also known as a “forward contract”.
This contract requires its participants to buy / sell a certain asset (underlying) at a specific future date at a certain price. It is built on the basis of a certain underlying asset at its current price and financing cost.
It is simple and common in all types of financial activity, for example:
“A company that exports to other countries, and is therefore exposed to the exchange rate between its local currency and the foreign currencies in which it is charged for its sales, can hedge its currency risk in advance by selling forward the currencies it expects. receive in the future ”. (Rodríguez, 1997).
“Forward (forward) contracts are similar to futures contracts in that they are both purchase or sale agreements for an asset at a specific time in the future for a specified price. However, unlike futures contracts, they are not traded on a market. They are private agreements between two financial institutions or between a financial institution and one of its corporate clients. ” (Hull, 1996).
In other words, forwards do not have to comply with the standards of a given market, since they are considered as over-the-counter instruments.
“In these operations the buyer (who assumes the long part), agrees to acquire the merchandise in question at a price and time agreed at the beginning. On the other hand, the seller (who assumes the short part), is willing to deliver the merchandise ”. (Díaz, 1998).
Forward contracts are divided into three modalities:
- They do not generate profits. They generate fixed profits or returns. They generate profits that are reinvested.
Fundamentally, these types of contracts are used for operations on currencies, this being the third modality, since its utility is represented by the interest rates of the currencies to which reference is made.
“For there to be a foreign exchange forward transaction, it is necessary that both the buyer and the seller are willing to carry out the negotiation, and a reference parameter is required regarding the current exchange rate and financial costs of the two countries involved during the period in which you want to carry out the operation ”. (Op. Cit.).
The price of the forward depends on the costs of each financial institution, the price premium in relation to the counterparty risk, the market situation and profits.
At the end of the term, two types of delivery can be given:
- a) They exchange the merchandise for the previously agreed value. b) “Exchange in favor or against in cash of the differential that exists between the price at which the operation was agreed at the beginning and the final price that the merchandise presents in the market at which is referenced ”. (Ibid.).
The main risk presented by the forward contract is that both parties fulfill their obligations.
Currently, most of these transactions are backed by product deposited in special warehouses or warehouses or based on future harvests or productions. In this way, the supply and marketing of various producers in the world are regulated.
An example of the first modality (the one that does not generate profits), is that of oil, since the storage of this product is very expensive due to the need for special facilities that have fire and pollution prevention measures. Furthermore, oil is relatively cheap per unit volume (as opposed to gold), so the cost of storage per unit value of oil stored is significant.
The second modality (the one that generates profits or dividends) is the case of forwards on bonds or stocks.
Finally, the forward on interest rates is also given, for example: “a contract with bank B whereby A and B agree to set a 10% annual rate for a period of one year to one year on the amount of preset money. After the year, if what A feared occurs and the interest rates drop to 8%, for example, Bank B will pay what A feared A the difference between the agreed rate (10%) and the current market rate (8%), that is, 2% of the agreed amount of money. If, on the other hand, the rates rise to 12%, A must pay the difference to B ”. (Rodríguez, 1997).
Futures
Broadly speaking, a forward contract is nothing more than a kind of forward contract but standardized and negotiable in an organized market (intra-market instruments), that is, a future contract is much more detailed than a forward (see table No.1), includes details such as quantity, quality, delivery date, delivery method, etc.
This type of contract has margins and capital that supports its integrity.
All positions handled in these (futures) contracts are between a participant on the one hand and the clearing house on the other.
Table No. 1: Differences between futures and forwards
|
FEATURES |
FORWARDS |
FUTURES |
| Type of contract | Private contract between two parties | Negotiated on changes |
| Not standardized | Standardized contracts | |
| Weather | Usually does not specify a delivery date | Categories of possible delivery dates |
| Adjustment | Start and end of contract | Adjusted to the market daily |
| Delivery method | Delivery of physical asset or final settlement in cash | Are settled before delivery |
| Size | It can be any size desired by both parts of it | The size is defined in advance |
| Underlying Specifications | Does not specify the underlying | Allowable variations in the quality of the deliverable underlying against futures positions are limited |
| Warranty | Does not specify any type of security deposit | There is always a clearing house that supports the market and needs security deposits |
| Compensation form | They are not compensated daily | All open futures positions in the market are valued every day |
| Type of markets | They are not traded on organized markets | They are always traded on organized markets |
| Liquidity | They usually do not generate liquidity | They always generate liquidity |
| Scape valve | It is not transferable | If it is transferable |
| Reliability | Doubtful | It is very trustworthy |
| Access to information | They are secret contracts | Buy - Sell "loudly" |
| Ease of negotiation | Everything is negotiated | Only the price is negotiated |
Source: Own elaboration based on: Fragoso (2002), Dubkovsky (2002), Díaz (1996), Bodie (1998) and, Rodríguez (1997).
Currency futures
In these types of contracts, two types of prices appear during their operation, the cash price and the spot price.
The cash price is that quoted by financial institutions based on the immediate supply and demand in the market.
This type of price is quoted at the moment in which the buyer and the seller agree. This type of price does not fluctuate over time.
Spot prices are currencies that will be delivered within 48 hours, their price will be determined by the supply and demand in the interbank market, in this market all authorized institutions that are dedicated to buying and selling currencies participate.
This market operates 24 hours a day and is through electronic systems and by telephone.
"The price of a currency depends on the cost of money that exists in the two countries to which the price refers.
The financial cost does not depend only on two countries, but also on the cost of the financial institutions that quote the currency. The difference that exists between the prices for the same currency is used to make arbitrations, which may be of a geographical nature or cross exchange rates. Geographical arbitrage exists when a currency is sold at two different prices in different markets.
In general, in this type of arbitration, profit can be obtained at the expiration of the negotiation ”. (Díaz, 1998).
When one thinks of this type of contract to exercise a currency hedge, it lends itself heavily to commercial import and export operations, investments, or debts acquired in currencies other than those that are managed domestically.
For this type of operation, financial risks are divided into two: transaction risks (one currency is exchanged for another); and translation risks (refer to the danger of expressing the value of one currency in terms of another without a physical currency exchange).
For this type of coverage to be carried out, it is necessary to know the type of risk to which it is exposed, amount and date. With this, it is possible to carry out in the present the transaction that it intends to carry out in the future, in order to take advantage of current prices and be certain of future costs.
Interest rate futures
A forward interest rate contract is simply a hedge contract on an asset whose price depends solely on the level of interest rates.
The importance of this type of contract is that "currently, the total operating volume of futures contracts on financial instruments represents more than half the volume of this entire industry." (Op. Cit.)
The most successful futures par excellence are the future contracts on US Treasury bonds of between 15 and 30 years duration and on interest rates in Eurodollars.
There are two types of interest, the cash and the term; The first is the interest rate of an investment made for a period of time that begins today and ends after n years. The second interest rate is that which is implicit in the current cash rates for future periods of time.
Treasury bill futures contracts
In this type of contract the underlying asset is for example a 90-day Treasury bill, the party with the short position must deliver one million dollars in Treasury bills on any day of the three successive trading days. The first delivery day will be the first day of the delivery month, on which a 13-week Treasury bill is issued and on which a one-year Treasury bill has 13 weeks left to maturity.
"In practice, this means that the Treasury bill can have 89, 90 or 91 days until expiration when it is delivered." (Hull, 1996).
A Treasury bill is known as a discount instrument, since it does not pay a coupon and the investor receives only the nominal value at maturity.
“The underlying asset before the expiration of the futures contract is a Treasury bill with a maturity greater than 90 days with respect to the expiration of the futures contract. For example, if a contract expires in 160 days, the underlying asset is a 250-day Treasury bill. " (Ibid.).
The months in which these Treasury bills operate are quarterly (March, June, September and December).
“The physical delivery is made on new certificate issuances at 13 weeks and is made three days after the expiration date of the contracts.
The price of the contracts is determined by the current price of the instrument for delivery at a future date, based on a final price of 100 ”. (Díaz, 1998)
In this operation, the long position is the one that transfers the cash that covers the cost of the operation.
Futures contracts on Eurodollars
These types of contracts are short-term. "A Eurodollar is a dollar deposited in a bank, American or foreign, outside the US" (Hull, 1996).
These contracts are denominated by the interest rate known as the 3-month LIBOR (London International Offer Rate).
These are typically higher interest rates than those offered by Treasury bills and are normally non-transferable deposits and cannot be used as collateral on loans.
See the difference between the Treasury Interest Rate and LIBOR in table No. 2.
Table No. 2: Difference between the interest rate
|
Treasury bill interest rate |
LIBOR |
| It is the interest to which governments borrow | At a commercial loan interest rate |
| It is a futures contract on the price of the letter | It is an interest rate futures contract |
Source: Own elaboration based on: Hull (1996), Rodríguez (1997) and, Díaz (1998).
"A Eurodollar futures contract is settled in cash on the second day of trading in London before the third Wednesday of the month." (Hull, 1996).
The duration of the obligations of this type of futures contract is a measure of time in which the owner must wait on average until receiving his cash settlements.
The LIBOR rate is used for loans to companies in international markets, it is a floating rate and is determined by the negotiation of deposits between banks in the Eurocurrency market.
Future Cetes and TIIE contracts
These contracts are short-term instruments and are operated in Mexico. The CETES (Certificates of the Treasury of the United Mexican States), having as issuance terms 28, 91, 181 and 360 days. And they are auctioned weekly.
Its contract management is quarterly like the T-Bills and Eurodollars. These expire at 1:30 p.m. (Mexico City time) on the next business day of the third Wednesday of the month indicated in the contract, and their prices do not represent maximum operating limits.
"The maximum allowed position is 5,000 contracts in combination with every month, and no more than 150 contracts over the month closest to expiration during its last week of operation." (Díaz, 1998).
The TIIE refers to a 28-day instrument, it operates 12 months a year, "the contract amount is $ 6,000,000.00 pesos and the minimum fluctuation is one basis point, which is equivalent to $ 50.00 pesos. This instrument does not have maximum limits on price movements.
Its price is determined by the Bank of Mexico with maturity at 12:00 hours (Mexico City time) on the third Wednesday of the month to which the contract refers. Their maximum allowed position is equal to that of the CETES, these contracts are quoted in Mexican pesos facilitating their operation and there is no exchange rate risk, however, these documents have not presented any liquidity to date.
Equity or stock index futures
The futures on stock indices are standardized contracts that through them can take advantage of the trends of the stock markets and in turn hedges can be made on portfolios or baskets on stocks, without the need to go to the physical delivery of the product.
As an advantage of this type of futures contracts is that these derivative instruments offer enormous liquidity and are easy to execute, their transaction costs are low compared to transactions in shares.
Purposes:
- Protects from short-term downside. They allow you to quickly invest in a market. And, they also allow you to quickly change markets.
In Mexico, the operation of this type of contract has been low, for this reason it implies a high risk, since this type of contract is quoted in dollars, and changes in the exchange rate and interest rates are reflected.
Bibliography:
1.- Bodie, Zwi and Robert C. Merton (1999). Finance. Editorial Pretince Hall, Mexico.
2.- Rodríguez, by Castro J. (1997). Introduction to the Analysis of Financial Derivative Products. 2nd Edition, Editorial Limusa, México.
3.- Hull, John (1996). Introduction to Futures and Options Markets. Editorial Prentice Hall, Spain.
4.- Díaz, Carmen (1998). Futures and Options on Financial Futures. Editorial Prentice Hall. Mexico.
5.- Dubkovsky, Gerardo (2002). "Options, futures and other derivative financial products"; Taken from session 2 of the Virtual University of the Tecnológico de Monterrey System, Mexico.
6.- fragoso, JC (2002). "Analysis and Administration of Financial Risks". Exposure of the subject of Risk Analysis, of the specialty in Financial Economics of the Veracruz University, Chapter 13: Derivatives Market, Xalapa, Ver.
