Disponible en Español

Course on Financial Instruments and Foreign Exchange Hedging Operations

Virtual course, from 27 to 31 July 2020.


The Course on Financial Instruments and Foreign Exchange Hedging Operations was held vir-tually from July 27 to 31, 2020, as part of the technical assistance program that the Center for Latin American Monetary Studies (CEMLA) offers to its members, in this case, the Central Bank of Bolivia. The course was attended by members of CEMLA, including: The Central Bank of Costa Rica, the Bank of Mexico, the Central Bank of Chile and the Central Reserve Bank of Peru.


Session 1. Introduction to financial instruments
In the first part of his presentation, Dr. Santiago García introduced fundamental elements in finance. He began by stating the functions of financial markets, such as the efficient allocation of resources, the transfer of risk among their agents, and the valuation of the financial instruments traded for these purposes. He proceeded to explain the difference in the value of money over time and discounts; also, the concepts of interest rates, their composition and notation, denomination and payment conventions, base changes and forward rates. Given the uncertainty on the states of nature, binomial trees are a valuation tool for some financial instruments. The law of a single price was stated and establishes that, if two instruments have the same flow structure, then their price should be the same.

Next, he explained the concept of a portfolio as a linear combination of securities; he introduced long and short positions, which consist of the purchase or the sale of a borrowed security, respectively. Positive scalars of the security in a linear combination correspond to long positions; negative scalars, to short positions. The principle of no-arbitrage was stated and establishes that it is not possible to obtain risk-free profits.

In the last part of the session, Dr. Garcia introduced financial instruments. He started with bonds, which are defined as those instruments that consist of a payment of a fixed amount (principal) on a maturity date. A bond may pay coupons, which are intermediate payments between the issue and the maturity date. The following values serve as sensitivity measures for the bond with respect to the interest rate: i) the Macaulay duration, which is the weighted average of the bond's flow maturities; ii) the modified duration, which is the logarithmic derivative of the bond's valuation with respect to the interest rate, and iii) the convexity, which is the second derivative of the bond's valuation with respect to the interest rate.

Session 2. Financial derivatives
Continuing the presentation of Session 1, Dr. Garcia talked about futures. They are financial instruments in which one party agrees to purchase and another party agrees to sale an asset at a fixed price on a fixed date. Using the principle of no-arbitrage, he derived the price for future contracts. Then, he talked about forwards, or contracts similar to futures, whose main difference is that they are traded in Over-The-Counter (OTC) markets, whereas futures are traded in established markets. He also commented on swaps, an instrument that involves the periodical exchange of cash flows, he gave examples of interest rates swaps, and, finally, he talked about other types of swaps. Lastly, he discussed about European options, a contract that grant to the owner the option to buy or sell an underlying asset at a given date at a fixed price, known as the exercise price. The purchase options are named calls; sell options are called puts. He explained the relationship between a put and a call, known as the put-call parity. It states that the difference in value between the call and the put at one point in time is equal to the difference in value of the underlying asset and the strike price; he also stated the Black and Scholes valuation model, its assumptions and the sensitivity measures, known as the Greek measures, that allow the analysis of the risk to which the instrument is exposed regarding changes in the value of the underlying asset, volatility, the risk-free rate and time. In the final part of this section, he presented some combinations of options, as well as the resulting hedging or investment strategy.

Finally, Dr. Garcia presented study cases of the usage of derivatives, such as the currency hedging in Banco de México and the Central Bank of Brazil, or the oil price hedging to guarantee economic budgets of the Mexican government; he also showed the case where the speculation with derivatives resulted in severe losses for a private company.

Session 3. Measurement of financial risks
Mr. Pablo Villa Michel began his presentation by introducing various concepts of risk management. He explained the definitions and mitigation mechanisms of credit, market and liquidity risks. He defined credit risk as the losses associated with a possible default on a credit contract and proposed the portfolio diversification, collaterals or credit derivatives as mitigation measures. For liquidity risk it considers two types: balance sheet risk associated with the difficulty of meeting commitments to third parties, and market liquidity risk associated with losses from the sale of assets or financial instruments under unfavorable conditions; as mitigation mechanisms, he proposes an adequate flow management considering unexpected situations, an investment policy resorting to exposure limits, and incremental sources of funds. Then, he defined market risk as the changes in the value of balance sheet items due to fluctuations in market prices. Mitigation may be achieved through effective investment policies according to risk factors and the maturity of the investment, limits on valuation losses, market-based strategies, as well as hedges through derivatives. He spoke about the effects of diversification as a risk reduction mechanism.

Second, he defined the concept of Value at Risk (VaR) as the percentile α obtained from a distribution of profits and losses (P&L) and commented on its application as a measure of market risk. He presented the Parametric VaR, when it is assumed that P&L has a certain distribution, in this case, a normal distribution. The sum of the VaR of each instrument is not necessarily equal to the VaR of the entire portfolio due to diversification. He presented the formulas for the calculation of the parametric VaR of a portfolio. It might be the case that the empirical P&L do not follow a normal distribution, which can be tested with statistical analyses or backtesting. He later proposed the Non-parametric VaR, a methodology that does not assume normality by considering the observed distribution of the elements in the portfolio and assumes stability over time of the volatility. Finally, he also proposed a VaR an autoregressive process of the conditional variance of the observations (GARCH), in which the hypothesis of a stable volatility is not necessary.

Then, Mr. Villa Michel analyzed two methodologies for measuring liquidity risk: one from the exogenous spread, which considers a liquidity VaR (LVaR) based on a VaR with a penalization for the liquidity costs based on the differences in the bid-ask spread; another methodology considers the endogenous spread based on a penalty proportional to the VaR affected by a factor calculated from the price sensitivities of the portfolio securities given by the elasticity of their demand.

Finally, he briefly discussed risk management as a process of institutional governance based on the identification of risks, their exposure, measurement, monitoring and the design of a strategy for risk mitigation or acceptance based on effective communication of quantitative information.

Panel 1. Financial risk management
Pablo Villa Michel, Andrea Miranda and Andrea Cayumil gave a description of the use of derivatives and the corresponding risk management. They spoke about regulatory aspects, investment policies and strategies, and risk mitigation schemes within their institutions.

Panel 2. Experiences of central banks in the region
Andrea Irene Miranda, Manuel Tapia and Óscar Giusti presented cases of the usage of derivatives in their respective institutions for the hedge of international reserves, the control of liquidity in foreign currencies and the control of exchange rate volatility, among others. They emphasized the importance of these financial instruments in the design of strategies for currency hedging with minimal or nonexistent impact on the international reserves.


Monday, July 27

Welcome remarks
Karina Revollo, Human Resources Manager, Banco Central de Bolivia
Serafín Martínez Jaramillo, CEMLA.

Session 1. Introduction to financial instruments
Santiago García Verdú, CEMLA.

Tuesday, July 28

Session 2. Financial derivatives
Santiago García Verdú, CEMLA.

Wednesday, July 29

Session 3. Measurement of financial risk
Pablo Villa Michel Morales, Banco Central de Costa Rica.

Thursday, July 30

Panel 1. Financial risk Management
Pablo Villa Michel Morales, Banco Central de Costa Rica;
Andrea Irene Miranda Portela, Banco de México;
Andrea Cayumil Fernández, Banco Central de Chile.

Friday, July 31

Panel 2. The experience of central banks in the region
Andrea Irene Miranda Portela, Banco de México;
Manuel Tapia, Banco Central de Reserva del Perú;
Óscar Giusti, Banco Central de Chile.



Serafín Martínez-Jaramillo
Serafin Martinez-Jaramillo is a senior financial researcher at the Financial Stability General Directorate at Banco de México and currently he is an adviser at the CEMLA. His research interests include: financial stability, systemic risk, financial networks, bankruptcy prediction, genetic programming, multiplex networks and machine learning. Serafin has published book chapters, encyclopedia entries and papers in several journals like IEEE Transactions on Evolutionary Computation, Journal of Financial Stability, Neurocomputing, Journal of Economic Dynamics and Control, Computational Management Science, Journal of Network Theory in Finance and some more. Additionally, he has co-edited two books and two special issues at the Journal of Financial Stability. Serafin holds a PhD in Computational Finance from the University of Essex, UK and he is member of the editorial board of the Journal of Financial Stability, the Journal of Network Theory in Finance and the Latin American Journal of Central Banking.

Dr. Santiago García Verdú
He is currently a research advisor at CEMLA. With a long career at Banco de México. He has served as Advisor to the Governing Board from 2012 to 2018, as Economic Researcher of the General Directorate of Economic Research of Banco de México from 2009 to 2011. He has a PhD in Economics from the University of Chicago (2009), a Master's Degree in Engineering from Princeton University (2001), and a B.A. in Applied Mathematics from the Instituto Tecnológico Autónomo de México (ITAM) (1999). Previously, he worked as an Associate Professor in the Economics Department and in the Master's Degree in Finance at ITAM. Between 2002 and 2003, he was Assistant Manager of Exploration and Production of Petróleos Mexicanos (PEMEX). He has also worked as a consultant.

Pablo Villa Michel Morales
He is the Director of Integral Risk Management of the Central Bank of Costa Rica since 2014 and is responsible for the implementation of the institutional project of Integral Risk Management. He has promoted improvements to the Bank's risk management policies and processes and developed the internal risk management certification course. He has extensive local and international experience in the financial industry and risk management. He graduated from the Masters in Financial Economics and Applied Macroeconomics at the Pontificia Universidad Católica de Chile, and is internationally certified by several institutions in financial and operational risk management, as well as a specialist in data science. He has experience as a professor and a researcher in economics and finance.

Andrea Irene Miranda Portela
Andrea Miranda Portela is Head of Financial Risk Monitoring at Banco de México, where she is in charge of supervising financial risk models, valuation and monitoring of the International Reserve's investment portfolios, as well as the assets that the Central Bank uses for foreign exchange hedging and liquidity schemes in its role as a lender of last resort. Andrea has worked for 8 years in the financial risk area for regulatory entities within the Mexican financial system surveilling local and international markets. Andrea has a Master's degree in Finance from the London Business School.

Andrea Cayumil Fernandez
She is currently head of the management and market analysis group of the Financial Markets Analysis Management of the Central Bank of Chile. In this role, she has implemented the international reserves asset valuation methodology and the metrics for the financial management and risk assessment of the institution's portfolios. These methodologies have allowed for a comprehensive view of the international reserves of the Central Bank, allowing for a unique methodology at the institutional level for the full range of instruments that make up the portfolios. Previously, she worked in the Financial Risk Management Department, being responsible for the Financial Operations Committee, in which she reports on the performance and risk profile of international assets and the projection of the short-term balance sheet of Banco Central de Chile. Before joining the Central Bank, she worked in academia and research, as well as in advisory and consulting activities. She has an economics background, with a Master's degree in Applied Economics from the Universidad de Concepción Chile, and has 11 years of experience in the economic and financial markets world.

Manuel Tapia
He is a specialist of the Tactical Analysis of Monetary and Exchange Operations Department, in charge of the daily monitoring of the local money and exchange markets, as well as evaluating the impact that the monetary policy of the United States and other developed countries has on the exchange rate and, therefore, on the monetary policy and exchange intervention operations of the Central Reserve Bank of Peru. 

Oscar Giusti
He holds a Bachelor’s degree in economics from the University of Chile and a Master's degree in finance from the Massachusetts Institute of Technology (MIT). He has been working at the Central Bank of Chile for 9 years. He has worked as portfolio manager of international reserves and sovereign funds on the international trading desk department. He is currently the head of the department of international markets, where he is in charge of the portfolio managers and trading team of the reserves and sovereign funds. He has taught finance courses in several universities in Chile at undergraduate and graduate levels.