Financial Derivatives

Financial Derivatives and their importance in the global economic and financial context

Benjamin Schmitz B.

Market fluctuations and recurring oscillations have become part of the economic and financial reality. Therefore, tools to reduce the risk and financial detriments of companies given such fluctuations are becoming more and more necessary.

Financial derivatives are figures that aim to reduce the risks arising from the oscillations and volatility of currency prices or money prices, and that prevent situations where a sudden rise or fall in prices may affect a market player.

Considering the different needs of the companies, different figures have arisen that aim at the purpose described above. For the present article, we will analyze the four main ones, despite the existence of an infinity of solutions and particularities given the autonomy of the contracting parties and their respective needs: Forward, Financial Future, Financial Option and Swap.

It is important to point out that the specific derivative contracts are signed under the protection of a local derivative framework contract (the one proposed by the Association of Banks and Financial Institutions, “ABIF”, recognized by the Central Bank of Chile) or, in the case of international contracts, an ISDA Agreement (proposed by the International Swap and Derivatives Association). These framework instruments and their annexes complement and determine the way in which these derivatives are applied and executed.

Forward

This contract is probably the basis of the other types of financial derivatives, as it is the easiest to explain and apply. Here, the contracting parties agree to give and receive an amount of money at a future date, which is under an exchange rate or an interest rate, depending on whether it is foreign currency or a loan or deposit.

The foregoing is agreed by the parties in a consensual or written manner and constitutes a non-negotiable or rigid instrument. Considering the prior, in case the financial conditions fluctuate and any of the parties becomes affected, they will not be able to amend such conditions or counteract the situation under the same executed contract.

The Forward has several modalities, being the most known and used the Forward Rate Agreement and the Forward Spread Agreement. Nevertheless, we find other figures and types, such as the Break Forward and the Range Forward, which aim at different purposes.

Financial Futures

This is an agreement where one of the parties undertakes to buy a certain financial asset or currency on an established date for a price fixed in the contract.

They are very similar to the Forward contracts explained above, but these are mostly regulated and treated, being traded on the stock market by authorized entities.

Financial Option

In these instruments we must distinguish two modalities:

1.-Call: through this option a right is acquired to buy a certain financial asset in the future, for a previously agreed price.

2.- Put: through this option a right is acquired to sell a certain financial asset in the future, for a previously agreed price.

These contracts, like Financial Futures, can be traded on the stock market, where they are managed by Brokers who may earn a fee for the transactions they carry out, depending on the conditions and whether or not the Call or Put options are exercised, as the case may be.

Swap

In simple terms, the Swap or Financial Swap consists of an agreement where two parties agree to exchange certain amounts of money on future dates. This can be under different currencies, or under the same currency. In this contract, what is exchanged corresponds to the economic obligations of the parties, and not to the legal obligations contracted by virtue of a contract or their legal positions with respect to a certain instrument.

The ultimate purpose of this type of contract is to take advantage of certain market inefficiencies, making use of the better economic situation of one company in a given market compared to another. Therefore, there is an exchange, in which both parties take advantage of the imperfections of the markets in which they usually operate, each contracting an obligation in the place where the best conditions exist according to their needs.

According to the different scenarios, Swaps can adopt different modalities, such as coupon swap, plain vanilla, basic swap, swap with options, among others.

Final Observations

Financial derivative contracts are necessary and appropriate for the correct functioning of the market. They are adaptive and dynamic figures, which attend to market fluctuations and constant change. Undoubtedly, understanding their different figures and aptitudes can help companies and entities to make adequate financial and economic decisions, anticipating scenarios and foreseeing risks, which is something necessary under any context and for any business.