By: Benito Revah and Genoveva Ayala

In the current globalization environment, companies are constantly exposed to financial and operation risks that should be covered to guarantee, with greater certainty, the present value of the expected flows.

Some of the functions to be performed by the Finance and Planning Committee in all Corporate Government Councils of Companies are the collaboration to identify the risks to which the corporation is subject and to evaluate the mechanisms to control them.

The internal control system is the process followed by management to comply with the following objectives: a) prepare reliable financial information b) safeguard the assets, c) increase the efficiency of the transactions, and d) comply with the laws and standards in effect.

The problems generated by the use of derivatives have to do with the difficulty of understanding their application to risk management or for speculation purposes. These problems highlight the need to develop internal control systems to regulate these transactions.

It should be remembered that a member of the Board of Directors, as an independent director, has to assess and give an opinion on the investment and financing policies proposed by top management.

There are two essential requirements to use derivatives: to have general knowledge of these instruments and their environment, and to formulate polices to manage these transactions.

General knowledge of derivatives and their environment

Derivative instruments are financial contracts that obtain their value and yield from underlying assets, such as bonds, physical commodities, interest rates or exchange rates, as well as a variety of stock indices amongst others. It is important to make sure that derivative risks are known, such as the high degree of leverage their operation implies, the volatility of the market, the risk of credit default and the lack of liquidity. Besides these technical risks, a fundamental risk is phased if the use of these products is not coherent with the organization’s policies and objectives; that is why one should understand perfectly well the hedging of operations’ or transactions’ risks through the use of derivative products, and these activities have to be aligned with the control systems.

Consultants have to understand their responsibility and thus authorize the use of derivatives after they have analyzed very thoroughly the expected risks and benefits. The contingencies generated can increase significantly if when doing these transactions with derivative financial instruments, the directors and officers of an entity do not have the knowledge or the experience on the risks implied by these transactions

Operation with derivatives policies

Non authorized speculation represents one of the higher risks in this market. Therefore, when the entity determines the objectives to contract and operate derivative financial instruments, the official documents describing the objective, the policies, and the procedures must be prepared and the persons who will make and monitor the operation of these instruments should be appointed.

The director must make decisions and should be aware of the degree of authority that he or she will delegate. Management has to have the competence needed to understand the transactions and the executives that participate in these transactions must have the technical knowledge and the operative experience.

Board members and top management need sufficient and timely information to see that the objectives and the strategies are complied with. Therefore, it is extremely important to convey promptly and accurately the positions to the control systems, and also the criteria and the risk measurements. The control activities must include procedures to identify, measure, assess and limit the risks in the use of derivatives, and also the information on the profitability of the transactions. They should preferably identify the following issues separately:

1. Benefits and losses realized in closed positions.

2. Unrealized benefits or losses in the contracts in effect.

3. Transaction costs.

4. Financing costs.

Ideally, the structure of the organization must create a control and supervision committee on the use of derivatives, that provides the necessary elements to top management so that it understands the risks of these activities, validates the results and assesses compliance with the established policies.

In conclusion, a good internal control on the use of derivatives should encompass four critical supervision areas, summarized as follows:

1. It is essential to train the directors, since they have to thoroughly understand the environment in which derivative transactions operate. An internal control system will not work if the personnel it affects ignores the nature of the risks it controls.

2. Have official documentation and clear policies on the entity’s objective in contracting derivative financial instruments,

3. Establish levels of authority that correspond to the organization’s needs, bearing in mind the experience of each employee and the functions each one has to carry out, to clearly limit their tasks performance.

4. Constantly communicate the positions, as well as the profitability levels, to determine if they are valued correctly. The format and content of this information should adapt to the company’s needs.

Operations with derivatives are and shall be every day more an essential tool to manage risk hedging in an organization. The relevance acquired by these transactions lead us to think that their importance will continue to grow with the development of new products focused on more efficiently achieving the hedging objectives. To the extent that they increase their knowledge on the management of these instruments, together with an effective control of their operation, the organization will be able to make better strategic decisions and with more certainty.?

Bibliography

American Institute of CPAS, Internal Control Issues in Derivatives Usage: An Information Tool.

Haro Pérez, J. y S. Cruz Rambaud. Control interno en operaciones con futuros y opciones. (Internal Control in operations with futures and options). Investigaciones Europeas de Dirección y Economía de la Empresa (European Research of Management and Economy of Companies).

Mosqueda Vélez, Miguel Ángel. (¿Cómo auditar instrumentos financieros derivados? (How to audit derivative financial instruments?), Instituto Mexicano de Contadores Públicos (Mexican Institute of Public Accountants, en.

Pérez Solórzano, Pedro Manuel. Los cinco componentes del control interno (The five components of internal control).