Derivative instruments for risk coverage

If we had to fix a reason why financial engineering arises, that would be the lack of stability: lack of stability in the exchange system, in interest rates, in the markets, in the solvency of the countries, and in short, greater risk in all financial operations. Many companies have found that this instability can cause difficulties in achieving expected cash flows, and in some cases, lead to bankruptcy or hostile takeovers. All of this has created the demand for financial instruments that manage this type of risk.

The rise of derivatives markets in recent years has been spectacular, basically caused by their use to hedge risks. And precisely, the possibility of separating the risk of fluctuations in the prices of the underlying physical operations of a company and managing them separately, through the use of derivative products, is the greatest of the financial innovations of the last decades. But it is that, in turn, as products are created for this purpose, their application is appreciated, not only in risk coverage, but also to cover other needs of the company.

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 financial swap operations, in addition of exposing the advantages that these products offer, with the aim of highlighting how, an appropriate use of them, can not only help to meet profitability objectives, but also to clearly reduce risk positions and achieve greater business efficiency.

Taking into account the above, the problem that is the object of study in this research is the insufficient use of derivative instruments to hedge the risk in Cuban companies.

The importance of studying the subject lies in understanding these changes because the dynamics of the world environment in economic and financial aspects have been in constant change and this requires the development of strategies to face them.

The hypothesis is that if there were a greater application of financial derivatives in Cuba then there would be a greater risk coverage for the changes taking place in the world economy.

This is of particular significance for Cuba in conditions in which the search for mechanisms that allow it to be inserted efficiently into the dynamics of the modern transformations that occur in the operations of the international economy is increasingly urgent. The handling of this issue in regard to its lessons, should focus on achieving higher levels of efficiency in Cuban business management, which is subject to the interaction of the laws of the world capitalist market and the risks that arise from it. derive.

Based on the problem and the importance of the issue raised in the work, specific objectives were set, including:

• Explain how financial risks can be managed within companies. Explain the generalities and potential of financial derivatives, advantages of their use, and use in Cuba to achieve greater business efficiency.

The research aims to provide the systematization and synthesis of each of the issues raised, which are scattered in the literature.

Perhaps some reflections should be pointed out about what this work does not propose, it does not attempt to postulate new theories and interpretations about financial derivatives or to incorporate all the important contributions of those who research in the field of international finance, they are only synthesized and continue the elaboration of certain traditional themes and interpretation and current considerations of capital importance for the purpose that it pursues.

During the development of the research there was a whole set of factors that to some extent limited its management, the greatest speed and accuracy among them is the dispersion of the subject in the literature and the diversity of criteria on it, its little treatment by Cuban specialists, which to some extent reduces the consultation framework on these aspects.

The work is structured in two chapters: the first, which deals with the management of business financial risk and the use of derivative instruments to hedge that risk, and the second chapter which explains the generalities of Futures, Options, Fras and Swaps, in addition to explaining the advantages of financial derivatives, focusing them towards a greater application in Cuba. At the end of the work, the conclusions of the research carried out are reached that give rise to recommendations, among them that Cuban companies that carry out transactions with companies worldwide must take into account derivative instruments to protect themselves from risk, fundamentally, with respect to the resounding changes in the value of products on world markets.

I. Financial risk management in the company

The risk framework in which companies operate has changed profoundly in the last decade, posing new challenges to the financial manager. In recent years, protectionist policies regarding the setting of prices of goods and services, interest rates or exchange rates have been abandoned; Trade restrictions have become more flexible and the economy has become globalized. The advances made in information technology and telecommunications allow the dissemination of information in real time and the design and use of increasingly complex financial instruments. There is no doubt that this new situation has a substantial impact on business activity, influencing its future results in one way or another.Many of these risks are inherent to the development of its own productive activity and are the so-called business, economic or corporate risks, linked to the manufacture and marketing of the company's products and services. The investor will be willing to assume this risk when the expected return is sufficient to compensate it, and it can be managed effectively through traditional tools, such as diversification. Apart from these business risks, companies are subject to other financial risks, which are increasingly exerting a greater influence on them.The investor will be willing to assume this risk when the expected return is sufficient to compensate it, and it can be managed effectively through traditional tools, such as diversification. Apart from these business risks, companies are subject to other financial risks, which are increasingly exerting a greater influence on them.The investor will be willing to assume this risk when the expected return is sufficient to compensate it, and it can be managed effectively through traditional tools, such as diversification. Apart from these business risks, companies are subject to other financial risks, which are increasingly exerting a greater influence on them.

Luis Diez and Juan Mascarenas call this risk an environmental risk, "it is one that affects the results of a company due to unforeseen changes in the economic environment in which it operates and which is totally beyond their control" (1). So this risk must be identified and measured, since the profitability of a company not only depends on how efficient its managers are to control the risk of the company's business, but it will also depend on how well they control environmental risk..

Among the risks to which a company is exposed we can highlight:

• Movements in the prices of raw materials Changes in the exchange rates of the currencies in which these raw materials are denominated Fluctuations in the price of energy, which is needed to process these materials Changes in the exchange rate of your own currency (if it increases, it will reduce its competitiveness abroad, the opposite happening if it decreases, if it is expressed indirectly) Changes in interest rates in your country, which will affect the cost of your indebtedness and, possibly, their sales income Alterations in interest rates in other countries, which will affect their competitors, and therefore, the behavior of the company's sales, etc.

The effect of market or environmental risks on companies has increased as the global financial environment has become more uncertain. However, it was not until recently that executives began to consider managing these risks, in order to limit potential losses and stabilize business flows. Faced with these situations, which can significantly affect the profits of companies, they consider their management in order to mitigate or lessen the probability of suffering losses. The first techniques that began to be used were based on balancing mechanisms or on actions that affected exploitation practices. In this sense, companies controlled their interest rate risks by aligning assets and liabilities of similar maturity.Similarly, export companies that did not want to be influenced by exchange rate risk built factories in their strategic markets; and those subjected to a greater extent to the risk of merchandise prices tried to avoid it by accumulating surplus stocks. However, these traditional techniques pose various difficulties. For example, the maintenance of surplus stocks of raw materials, as protection against future price increases, can affect the quality and quantity of production. In addition, the company risks losses if the prices of its stocks fall. They are also costly on certain occasions and do not always make it possible to manage a certain risk.export companies that did not want to be influenced by exchange rate risk built factories in their strategic markets; and those subjected to a greater extent to the risk of merchandise prices tried to avoid it by accumulating surplus stocks. However, these traditional techniques pose various difficulties. For example, the maintenance of surplus stocks of raw materials, as protection against future price increases, can affect the quality and quantity of production. In addition, the company risks losses if the prices of its stocks fall. They are also costly on certain occasions and do not always make it possible to manage a certain risk.export companies that did not want to be influenced by exchange rate risk built factories in their strategic markets; and those subjected to a greater extent to the risk of merchandise prices tried to avoid it by accumulating surplus stocks. However, these traditional techniques pose various difficulties. For example, the maintenance of surplus stocks of raw materials, as protection against future price increases, can affect the quality and quantity of production. In addition, the company risks losses if the prices of its stocks fall. They are also costly on certain occasions and do not always make it possible to manage a certain risk.and those subjected to a greater extent to the risk of merchandise prices tried to avoid it by accumulating surplus stocks. However, these traditional techniques pose various difficulties. For example, the maintenance of surplus stocks of raw materials, as protection against future price increases, can affect the quality and quantity of production. In addition, the company risks losses if the prices of its stocks fall. They are also costly on certain occasions and do not always make it possible to manage a certain risk.and those subjected to a greater extent to the risk of merchandise prices tried to avoid it by accumulating surplus stocks. However, these traditional techniques pose various difficulties. For example, the maintenance of surplus stocks of raw materials, as protection against future price increases, can affect the quality and quantity of production. In addition, the company risks losses if the prices of its stocks fall. They are also costly on certain occasions and do not always make it possible to manage a certain risk.maintaining excess stocks of raw materials, as protection against future price increases, can affect the quality and quantity of production. In addition, the company risks losses if the prices of its stocks fall. They are also costly on certain occasions and do not always make it possible to manage a certain risk.maintaining excess stocks of raw materials, as protection against future price increases, can affect the quality and quantity of production. In addition, the company risks losses if the prices of its stocks fall. They are also costly on certain occasions and do not always make it possible to manage a certain risk.

In order to solve the inefficiencies of traditional methods, new risk management techniques have been developed since the 1970s, which have resulted in the appearance of derivative financial instruments. Correctly used, they allow transferring the risks to which the agents are subjected without creating additional risks, allowing anticipating the favorable or unfavorable consequences of said changes. This fact makes it possible to limit potential losses and stabilize cash flows, also providing flexibility, speed, precision and low transaction costs. Although derivatives have been used for a long time, only recently have they come to be considered by company managers as a viable strategy in the active management of financial risks,accentuated by the current volatility of prices and financial assets.

Risk management can be used positively to drive the growth of a company, or defensively to protect its profits and its current market share. In any case, if it is managed properly, the risk will tend to decrease and if the cash flows stabilize the company will have better long-term results and an increase in its market price will be achieved. In short, the efficiency of your management will be improved. The company must be clear about its objectives with regard to risk coverage: stabilization of expected cash flows. The argument for this is that a company that knows the value that its collections and payments must achieve will be able to carry out better strategic planning while maintaining its competitiveness in the market.Risk coverage enables the budgeted benefits to be achieved with a high probability, which will affect the efficiency of the company

1.1. The derivatives market.

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 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 that there is no need for the monetary flow to occur for the total amount of the operation,Therefore, they allow risk coverage without the possibility of losing the entire principal in the event 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..

1.2. Main Operations of the derivatives market.

Derivatives have common features, worldwide, which are summarized.

1. 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.

1.3. Coverage.

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. In turn, this risk is only assumed if open positions are maintained, which are those in which the maturity term (or interest modification, if it is a financial instrument with a variable interest rate) of an asset does not coincides with that of the liability with which it is financed. When the term of the asset is longer than that of the liability, the position is called long and produces losses, when interest rates rise, or profits, when interest rates fall. Faced with variations of the same sign in interest rates, a short position (term of the liability greater than that of the asset) produces opposite results.

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. It is evident that with a long position with respect to a currency, a rise in the exchange rate of the national currency against it (depreciation of the foreign currency), will produce a decrease in profits, and an increase if the position were short. The third form of market risk to be considered,it refers to possible losses caused by variations in the price of equity securities. It is clear that if these variations are due solely to changes in interest rates, it will be the first case of the aforementioned. However, the prices of this class of securities depend on a much broader set of factors, among which the solvency of its issuer stands out, which includes its ability to generate profits, which normally do not influence the market price of the liability with the one that finances the investment. It is, therefore, a form of market risk that is heterogeneous with respect to the previous ones.It will be the first case of the aforementioned. However, the prices of this class of securities depend on a much broader set of factors, among which the solvency of its issuer stands out, which includes its ability to generate profits, which normally do not influence the market price of the liability with the one that finances the investment. It is, therefore, a form of market risk that is heterogeneous with respect to the previous ones.It will be the first case of the aforementioned. However, the prices of this class of securities depend on a much broader set of factors, among which the solvency of its issuer stands out, which includes its ability to generate profits, which normally do not influence the market price of the liability with the one that finances the investment. It is, therefore, a form of market risk that is heterogeneous with respect to the previous ones.in a form of market risk that is heterogeneous with respect to the previous ones.in a form of market risk that is heterogeneous with respect to the previous ones.

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:

1. the amounts, dates or terms, and 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.

It is for this reason, obviously, as long as the desired counterpart is found exactly, the "tailored" operations present the highest degree of precision in the hedging.

It is clear that, if the underlying asset of the hedging operation is not the same as the one that originates the risk, at least the factors that influence the variability of the price of both and its magnitude must be as similar as possible. as possible. Hence, from the three forms of market risk mentioned, the three most important organized markets for futures and financial options will emerge, after the process discussed below: on interest rates, on currencies and on securities or stock indices.

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.

Similarly, it should be noted that as a general rule, a long or long position in the cash asset is covered with a short or short position in the futures market. The reverse situation, that is, a "short" position in the cash asset, is covered by a long or long position in the futures market.

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.

II. Financial derivatives

2.1. 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 futures, among which those used on Stock Indices and on Shares stand out.

2.2. The options

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.

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 call option (long call) Sale of call 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 both parties are obliged to carry out the sale when the expiration date arrives, is broken in the options since one of the parties (the option buyer) has the right, but not the obligation to buy (call) or sell (put), while the option seller will only have the obligation to sell (call) or 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. The exercise of a call option generates a long position for the underlying for the holder of the call option and a short position for the seller of the option. The exercise of a put option, instead,generates a short position of the underlying for the holder of the put and a long position for the seller of the put. Therefore, for each option exercised, an open position is generated in the underlying.

Also specify that an option has five fundamental characteristics that define it, these being the type of option (buy -call- or sell-put-), the underlying or reference asset, the amount of underlying that allows buying or selling the contract of option, expiration date and option strike price. Options can be exercised at any time until expiration (American options) or only at expiration (European options). The comparison between the exercise price and the price of the underlying asset is used to determine the situation of the option (in, at or out of the money) and its convenience to exercise it or allow it to expire without exercising the right granted by the purchase of the option.

Depending on the Strike Price and the Underlying Price (or the price of the shares) at any given time, we can classify the Options as: “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 exercise price is lower than the price of the underlying, while a put option is "in the money" when the exercise price is higher than the price of the underlying; Of course, an option is “out of the money” when the opposite situation to that described above for “in the money” options occurs, with the exception of options that are “at the money” which only happens when the price of exercise and price of the underlying match.

According to this classification we will have to:

A Call Option will be:

• “In the money” if your Strike Price is less than the share price. “Out of the money” if your Strike Price is greater than the share price. “In the money” if your Strike Price is equal or very close to the share price.

A Put Option will be:

• “In the money” if your Strike Price is higher than the share price. “Out of the money” if your Strike Price is less than the share price. “In the money” if your Strike Price is equal or very close to the share price.

2.2.1. The Strike Price.

The Strike price is the price at which the option buyer has the right to purchase (Call option) or sell (Put Option). Options with the same Strike Price and the same expiration are called “series”. The Strike Price is not unique, so you can buy / sell call and put options at different strike prices. If an Option is exercised before the expiration date, an "Early Exercise" is said to have occurred. If an Option is not exercised early, but is allowed to reach the expiration date and is then exercised, it is said that "Exercise to Expiration" occurs.

In view of the aforementioned, specify that the Early Exercise is known as the one carried out on a date other than the expiration date. In this case, when exercising the right, we buy (in the case of a Call Option) or sell (in the case of a Put Option) shares at the Strike Price.

In this way, when the buyer exercises his right, he will oblige the seller of the Option to sell (in the case of a Call Option) or to buy (in the case of a Put Option) shares at the Strike Price.

The Exercise to Maturity is known as the one that occurs on the maturity date. This exercise will be automatic, unless the holder expressly states it, for those Options that are "in the money", since an Option "in the money" is one that when exercising it produces a profit.

The reference price that tells us if an Option is "in the money" is called the Weighted Average Price. It is the average of the price of all cross stock trades on the day, weighted by volume.

In this way, all those Call Options "in the money" will be exercised at Expiration, that is, those with a Strike Price lower than the Underlying Price and all those Put Options "in the money", that is, those with a Price of Exercise greater than the Underlying Price.

2.2.2. 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.

PREMIUM = INTRINSIC VALUE + EXTRINSIC OR TEMPORARY VALUE

A significant element is knowing how the Premium is determined, for this the following factors must be taken into account:

1. Price of the share today (Price of the Underlying Asset) Price at which we want to secure the price (Strike Price) Time during which we want to secure that price (Time to Expiration) Dividends paid by the share during that period (Dividends) Interest rate free of risk that exists at that time (Interest Rate) The expectations that the investor has about how much and how often the price of the underlying will change in the established period (Volatility).

2.3. FRAs contracts.

The FRAs (Forward Rate Agreement) were created to guarantee the interest rate in investment and financing operations, replacing forward-forward deposits.

A Fra is a forward contract on interest rates by means of which two parties agree on the interest rate of a theoretical or notional deposit, with a term and for a specified amount, to be made on a stipulated future date. They make it possible 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.

2.3.1. Background of the FRA contracts.

FRAs or agreements on future interest rates were created to offer protection against fluctuations in future interest rates, especially those that take place within the interbank market. They are included within the OTC derivatives on interest rates. Its origin was the term contracting of deposits, called forward-forward deposits, since both the effective date and the repayment date are future. In this type of operation, the parties (borrower and lender) agree on the terms of a deposit that will be constituted on a previously stipulated future date. Through this type of contract, an institution can cover the risk of the renewal of a future loan or guarantee the interest rate for the placement of an investment.However, this type of instrument has two clear drawbacks that limit its operational potential and that have been the cause of its disappearance in favor of the FRAs. Specifically, these drawbacks are:

• It requires an effective movement of funds, which means that the financing alternative (or investment) and the hedging alternative must be the same.In order for financial institutions to be able to guarantee such future operations, without assuming any risk, they must carry out cash operations "Synthetic". For example, to secure a six-month loan that you will grant to a client within three, you must take a cash deposit for a period of nine months and simultaneously lend for a period of three, until the term operation begins. These operations suppose the financial institution a movement of funds as well as their appearance on the balance sheet, which originate direct and indirect costs. They also limit speculation or arbitrage operations.

2.3.2. Operational mechanics of cold operations.

In transactions 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 FRA contract is not a financing instrument, but a risk hedging instrument, offering those involved the elimination of the risk derived from possible fluctuations in interest rates.

The contracting parties are called the buyer and seller. The buyer of the FRA is the contracting party that wishes to protect itself from an increase in interest rate, acting as a hypothetical future borrower, while the seller of an FRA will be the contracting party that wishes to protect itself against a decrease in the interest rate, acting as a future hypothetical lender. Thus, 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 rate, the other counterpart being a financial entity that acts as counterparty.

In this type of contract, three dates are established:

1. t0: contract date, on which the contract is signed and the guaranteed interest rate is agreed, the theoretical or nominal amount of the operation, as well as the start date and the contract period. t1: contract start date, corresponding to the beginning of the theoretical operation that is intended to guarantee. On this date, the settlement occurs through the payment of the interest difference between the reference rate in force in the interbank market and the one agreed at the signing of the contract. T2: expiration date of the contract, corresponding to the expiration of the theoretical operation.

The period of time between the signing of the contract and its beginning is called the waiting or deferral period, while the period between the latter and its completion would be the duration of the contract or the guaranteed period. In practice, FRAs are named based on the moment in which the contract begins and when it expires, so that in an FRA in which the contract start date is 6 months and its end is 9 months later. months would be a “six versus nine” FRA or FRA. In this operation, the duration of the contract or the period to be guaranteed would have a duration of 3 months.

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. They have no liquidity in longer terms, so they are useful for managing rates 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. To do this, it would buy a FRA3 / 9 for a nominal amount of 100,000 Euros.

If the agreed rate at the time of signing is 5% on an annual basis, the following situations could occur at the time of initiation of the contract when the settlement for differences is carried out:

• That the market interest rate is higher than 5%. In this case, it would be the selling entity of the FRA who should assume the difference, since the cost of the deposit will be higher than the guaranteed one. That market rate was 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 FRA contract ensures that the interest rate to pay for a deposit of 100,000 euros at three months to obtain within three months will be 5%, once the

2.4. Interest Rate Swaps (IRS).

Financial swap operations or swaps have undoubtedly become the fastest growing derivative financial instrument in the last fifteen years worldwide. Swaps are contracts in which two economic agents agree to exchange monetary flows, expressed in one or more currencies, calculated on different types or reference indices that can be fixed or variable, during a certain period of time.

The fundamental application of this financial instrument, and which has produced its spectacular growth, is the management of financial risks, the reduction of financing costs, arbitrage between markets or the creation of synthetic financial instruments.

2.4.1. Definition and classification of interest rate swaps (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, given that the most 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, over a set period of time,a mutual exchange of periodic interest payments denominated in the same currency and calculated on the same principal but with different reference rates. In the most common case, one of the parties pays interest at a variable rate based on the EURIBOR or LIBOR, while the other does so at a fixed or variable rate, but referenced, in this case, to a different base.

In basic or “plain vanilla” operations, the variable rate is quoted without margin, so this can be offset with the flows at a fixed rate, so that in the swap of the previous example, a fixed rate of 6% would be paid in exchange for receive the EURIBOR. In these operations, the payment obligation affects exclusively the exchange of interest. The principal, although it helps us to evaluate the size of the swap, is not exchanged, serving only to calculate the interest to be paid. For this reason, these operations do not have an impact on the accounting balance sheets of the participating companies (they only influence the profit and loss account), and are therefore classified as off-balance sheet instruments. Payments that both parties must periodically exchange are usually offset by making only one payment for the difference.This compensation is known as “netting” and will be given by: There are two basic or generic types of interest rate swaps, the so-called:

• Fixed versus variable swaps or “coupon swap”, in which a fixed rate flow is exchanged in exchange for another variable rate Variable versus variable swaps or “basis swaps”, in which two interest flows are exchanged calculated at the rate variable, such as EURIBOR 3 months against EURIBOR 6 months, EURIBOR 3 months against LIBOR 3 months, 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.

2.4.3. Risk coverage with interest rate swaps.

Risk coverage consists of taking a risk position to compensate for another of the same amount, but opposite. Since the swap creates an exposure to interest rate risk, it can also be used to hedge exposures produced by other financial instruments. It should not be forgotten that the philosophy of hedging consists of maintaining opposite positions so that possible losses in one of them are offset by gains in the other.

2.4.5. Speculate or take risk positions.

Given that any swap exposes us to risk due to possible variations in interest rates, it can also be used to take risk positions based on our assumptions about the future evolution of these rates. We must not forget that, in this case, losses may occur if our expectations are not met since there is no other position with which to compensate them, as in the case of hedging. Risk positions can be assumed independently or together with other derivative assets.

2.4.6. Use of swaps to take independent risk positions.

In this case, risk positions are taken independent of any other position in other instruments. It simply consists of making, independently, one of the structures seen in the previous sections, depending on our future expectations:

• If we believe that interest rates are going to fall, we could carry out a coupon swap, through which we receive the fixed rate, in exchange for paying the variable rate, obtaining a profit in the event that our expectations are met. interest rates are going to rise, we could carry out a coupon swap, for which we pay the fixed rate, in exchange for receiving the variable rate, obtaining a profit if our expectations are met If we believe that the two benchmarks will evolve in a different way, we will carry out a bases swap that benefits from said variation.

  4.7. Arbitration operations.

An arbitrage is a simultaneous purchase and sale of the same commodity or financial asset at different prices to obtain a profit. In the case of arbitrage between a swap and a financial asset, although different instruments are bought and sold, they are similar in the sense that both generate interest calculated on the same benchmark. If one instrument generates a higher rate than another, both being calculated on the same index, then the arbitration will be carried out. A swap can be used to receive (or pay) interest calculated on the same reference rate, against a payment (or receipt) on a spot instrument that produces interest on the same reference. In an efficient market, in which cash assets and derivatives intervene,used by investors with the same access to information, the same prices should be maintained but, in practice, valuation differences arise that produce arbitrage opportunities.

Debt arbitration. If the counterparty to a swap has access to relatively cheaper than market loans, it can make a profit by trading in a swap that receives market interest. The arbitration would be carried out between a loan, which is cheaper than normal, and a swap at market rates for which a rate higher than that paid for the loan would be received, giving a positive difference to offset the variable rate that would have to be pay for the swap and, therefore, obtaining a variable rate financing cheaper than the market.

Arbitration with assets. Interest rate swaps, in addition to being able to be used to carry out arbitrations with spot instruments, reducing the cost of borrowing, can also be used to carry out arbitrations between assets and even derivative assets, achieving higher returns. As mentioned earlier, a swap that is used in conjunction with an asset is called an asset swap.

You can arbitrate with variable interest assets such as FRN's, certificates of deposit and commercial paper, FRA, futures, etc. These assets normally provide interest above the EURIBOR, while the floating rate received for the swap is usually without margin. The benefit that can be made between the variable rate received by the asset and the one paid through the swap is used to complement the fixed rate received by the swap, creating a synthetic asset at a higher fixed rate.

It has been seen that most swap arbitrage opportunities appear due to the different credit risk premiums demanded for the same issuer by different markets. In fact, some swaps were created to produce arbitrage opportunities and reduce the cost of new debt issues, hence this type of swap is known as a “new issue arbitrage” swap. In this way, if the differential in the cost of borrowing of two entities, depending on their credit rating, is different depending on the market in which it is carried out, a reduction could be obtained in it by borrowing in the most favorable market and then using a swap to achieve the desired type of debt.

Finally, as the advantages of these operations we can highlight that:

• They allow hedging positions that present interest rate risk, more economically and for a longer term than other hedging contracts (for example, futures). They present great flexibility when determining the conditions of the contract, since they are “tailor-made” instruments. Acting parties can determine the profile of interests that best suits their needs and characteristics.

Regarding the inconveniences of these operations we can highlight that:

• If there is no financial intermediary, the parties have to assume a credit risk. Although it is possible to cancel the operation, it can be expensive in the event that market conditions change.

2.5. 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 that are raised 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, as it would allow them to hedge against 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.

2.5.1 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.

Conclusions

1. Derivatives market instruments are very valuable for managing the financial risk that affects companies in today's world.The current conditions of the development of the Cuban economy make it necessary to use financial engineering instruments to hedge financial risk.

recommendations

1. Cuban companies that carry out transactions with companies worldwide must take into account derivative instruments to protect themselves from risk, fundamentally with respect to the dramatic fluctuations in the value of products on world markets. derivatives and analyze their advantages, as instruments to protect against unforeseen changes in the world economic environment in which the Cuban economy operates.

Bibliographic references

(1) Diez, Luis and Mascarenas, Juan: Financial Engineering. Management in International Financial Markets. McGraw Hill. Madrid. 1994. Page 422.

Bibliography

• Adell, Ramón y Romeo, Remedios: Options and financial futures. Pyramid, 1998.Brealy, RA and SC Myers: Foundations of Business Financing, 4th edition, McGraw Hill, 1993.Carranza, J.; L. Gutiérrez and P. Monreal: «The demonetization of the Cuban economy: a review of the alternatives», Revista Economía y Desarrollo, 2, Havana, 1995. Cuervo, García, A.; L. Rodríguez Saíz and JA Parejo Gámir: Manual of the Spanish Financial System, 5th, revised and updated edition, Ariel Economía, 1992. Fernández, Pablo: Options, Futures and derivative instruments. Deusto, Bilbao, 1996. Fernández, Pablo: Options and valuation of financial instruments, 1997. Freixas, Xavier: Financial futures. Alianza Economía y Finanzas, 1998 Diez, Luis y Mascarenas, Juan: Financial Engineering. Management in International Financial Markets.McGraw Hill. Madrid. 1994 Ketterer, Joan Antony and Larraga, Pablo (1997): The financial futures market. Papers of Spanish Economy, num. 29. Financial System Supplement Lamothe, Prosper: Financial Options. A fundamental approach. Mc Graw Hill, 1997 Larraga, Pablo and other authors: Futures on Index. Ediciones Cinco Días, 1998. Martín, José Luis y Ruiz, Ramón Jesús: The investor and financial markets. Ariel Economía, 1997. Mauleon, Ignacio: Investments and financial risks. Espasa Calpe.Ontiveros, Emilio y Berges, Angel: Futures markets in financial instruments. Pirámide, 1999.Valero, Francisco Javier: Options and financial instruments. Ariel Economics, 1999.Financial System Supplement Lamothe, Prosper: Financial Options. A fundamental approach. Mc Graw Hill, 1997 Larraga, Pablo and other authors: Futures on Index. Ediciones Cinco Días, 1998. Martín, José Luis y Ruiz, Ramón Jesús: The investor and financial markets. Ariel Economía, 1997. Mauleon, Ignacio: Investments and financial risks. Espasa Calpe.Ontiveros, Emilio y Berges, Angel: Futures markets in financial instruments. Pirámide, 1999.Valero, Francisco Javier: Options and financial instruments. Ariel Economics, 1999.Financial System Supplement Lamothe, Prosper: Financial Options. A fundamental approach. Mc Graw Hill, 1997 Larraga, Pablo and other authors: Futures on Index. Ediciones Cinco Días, 1998. Martín, José Luis y Ruiz, Ramón Jesús: The investor and financial markets. Ariel Economía, 1997. Mauleon, Ignacio: Investments and financial risks. Espasa Calpe.Ontiveros, Emilio y Berges, Angel: Futures markets in financial instruments. Pirámide, 1999.Valero, Francisco Javier: Options and financial instruments. Ariel Economics, 1999.Investments and financial risks. Espasa Calpe.Ontiveros, Emilio y Berges, Angel: Futures markets in financial instruments. Pirámide, 1999.Valero, Francisco Javier: Options and financial instruments. Ariel Economics, 1999.Investments and financial risks. Espasa Calpe.Ontiveros, Emilio y Berges, Angel: Futures markets in financial instruments. Pirámide, 1999.Valero, Francisco Javier: Options and financial instruments. Ariel Economics, 1999.

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As a complement to the topic of derivative instruments to hedge financial risk, we suggest the following video-course, given by Professor Xavier Puig, from Pompeu Fabra University, in which the most important concepts of these financial tools are explained. (9 videos - 3 hours, 51 minutes)

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