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CHAPTER 7

CHAPTER 7. FUTURES DERIVATIVES. Learning Objectives. Describe a derivative Describe the history of derivative Describe the development of derivative in Malaysia Explain the difference between forward and futures contract

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CHAPTER 7

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  1. CHAPTER 7 FUTURES DERIVATIVES

  2. Learning Objectives • Describe a derivative • Describe the history of derivative • Describe the development of derivative in Malaysia • Explain the difference between forward and futures contract • Explain terms convergence, margins and marking to market and basis risk • Explain the terms hedging, speculating and arbitraging with futures • Describe the contract specification of FCPO and FKLI • Know how to hedge, speculate and arbitrage using FCPO and FKLI • Explain and understand the term single stock futures

  3. Chapter Outline • Introduction to Derivatives • Forward and Futures Contracts • The Key Elements of in Futures Trading • Hedging, Speculating and Arbitraging with Futures Contract • The Crude Palm Oil (FCPO) and KLCI (FKLI) futures • Single Stock Futures (SSF)

  4. What is a derivative? • The word ‘derivative’ implies they derive their value from something. • It originates from mathematics and it is a variable that derives from another variable. • Derivatives on its own have little value but when it derives from some other asset, known as the underlying, hence, it has its value. • The underlying can be share prices, prices of commodity, indices and interest rates. • For example, a derivative of Air Asia shares will derive its value from share price of Air Asia (underlying). • Similarly, a derivative contract on Crude Palm Oil depends on the price of palm oil and the derivative of Kuala Lumpur Composite Index (KLCI) will depend on the movement of the KLCI.

  5. Why do derivative markets exist? • Largely to facilitate hedging. • The derivative markets are largely insurance markets. • Firms, like individuals are risk averse and would like to protect themselves against three main types of risk that businesses face: PRICE RISK, CURRENCY RISK and INTEREST RATE RISK.

  6. SPOT MARKET vs FORWARD/FUTURES MARKETS • In the spot (cash) market, buyers and sellers agree on Price (P) and Quantity (Q) for immediate delivery (or within a few days). • Example: Proton buys 1 million Japanese Yen in the spot market for currency, or it buys 100 tons of steel in the cash market for steel. MAS buys 500,000 gallons of gasoline in the spot market.

  7. FORWARD CONTRACT • Private contracts between two parties (buyer and seller) for delivery sometime in the future (one month, one year). • Not marketable securities and there is no secondary market. • E.g. like the difference between a bank loan (not marketable) and a bond (marketable).

  8. Mechanics of Forward Contracts: An illustration • Assume there are 2 parties – a cocoa farmer who has planted cocoa on his farm and is expecting to harvest the cocoa in 6 months and a confectioner who produces chocolate using cocoa powder. • Assume further that the confectioner has in his inventory, sufficient cocoa to last him for the next 6 months, but would have to replenish his stock at the end of the sixth month. Clearly, both parties here are exposed to risk, in this case price risk.

  9. The cocoa farmer faces the risk that the spot price of cocoa could fall between now and 6 months from now, when he completes his harvest. Such a fall will obviously reduce his revenue and profits. Infact, if the fall in spot price is sharp enough, he could even face outright losses. • The confectioner faces similar risk but in the opposite direction. The spot price of coca could increase between now and 6 months from now when he needs to replenish his inventory. Any increase in prices will increase his costs and reduce his profits.

  10. Since both parties face price-risk and neither party can tell which way prices would go, it would be in their interest to go into an arrangement that could protect them from this price-risk. Such an arrangement would be the forward contract. Under the forward contract, the farmer would agree to deliver and the confectioner to take delivery of cocoa of an agreed quantity on a mutually agreeable date and at a price determined now – i.e. at the time of initiation of contract.

  11. Step 1 (at initiation of contract; day = 0) negotiate Confection (Long Position) Farmer (Short position) Agree on : Price, quantity, quality, maturity delivery location etc. Step 2 (on maturity date; day = 180) Cocoa Farmer (Short position) Confection (Long Position) Money The long position agrees to take delivery (buy) of the underlying asset while the short position agrees to make delivery (sell).

  12. FORWARD CONTRACTS – EXAMPLE 1 • Giant Supermarket enters into a forward contract in May to purchase rice at harvest time in October, at a guaranteed price, from various rice farmers for their entire crop. • Advantage: buyer (company) and seller (farmer) gave a guaranteed price. They are now protected from price swings in rice. • They have eliminated price risk completely by hedging their position, locking in a price with a forward contract.

  13. FORWARD CONTRACTS – EXAMPLE 2 • Toyota Motors enters into a contract for British pounds with Bank One, to either buy pounds or sell pounds, in six months at a guaranteed exchange rate. By locking in, Toyota Motors has hedged currency risk.

  14. Advantages/Disadvantages of Forward Contract • Advantage: They are very flexible and can be customized to the needs of the parties. • Disadvantages: • There is no liquid market for forward contracts, no secondary market. • Problem in price fixing. The party who has better negotiating power may dictate an unfair price. • High default risk. One party may default (not fulfilling the future obligation agreed upon earlier), resulting in losses for the other party. This risk is known as counterparty risk. • Requires actual delivery to complete the contract..

  15. FUTURES CONTRACTS • Are the same in principle as a forward contract, where two parties (buyer and seller) agree to trade/exchange something (rice, corn, oil, T-bills, Yen) in the future (one week, one month, one year), but they agree on P and Q now, for future delivery, using a futures contract from a futures exchange – an organized market for trading futures contracts.

  16. What is a futures contract? • exchange-traded form of forward contract • Basically to overcome 3 problems of forward contract • (1) multiple coincidence needs, • (2) unfair forward price and • (3) counterparty risk. • Because they are exchange-traded, the contracts are standardised. • Except for price the standardised contract would have specified the quantity (or the contract size), quality (or the grade) of the underlying asset, delivery date (or the expiry date) and location of delivery.

  17. Multiple Coincidence of Needs • At least three things must match before the two parties in a forward contract can even begin to negotiate prices. (i) asset match (ii) maturity match (iii) quantity match • There could be others such as delivery location etc. The result is that there could be substantial “search costs” involved. One party will have to search out the other thereby incurring costs in terms of time, advertisement etc.

  18. Potential for Price Squeeze/Unfair Price • In a forward contract, the forward price is arrived at through negotiation. • The problem with negotiation is that, bargaining position matters. If one party is in a weak bargaining position, he could be squeezed by the other. • However, if there is only one confectioner (potential buyer of cocoa) in the district but several cocoa farmers, the long position has the bargaining power and could dictate on price.

  19. In such a situation, even if the cocoa farmer feels the price offered may not be fair, he may have little choice but accept the price. This would be particularly so, if the product is perishable and could spoil shortly after harvest. The short position does not have much of an option to wait and see if he could fetch a better price post harvest.

  20. Counterparty / Default Risk • Counterparty risk or default risk, refers to the possibility that one of the parties to the transaction could default. Such default could happen not so much because the party is “dishonest” but rather due to the incentive to default given changes in the spot price. • However, if spot prices subsequently begin to fall, the long position (confectioner) begins to hurt since he has agreed to forward price based on the higher previous spot price.

  21. The opposite is true if spot prices begin to rise after the forward contract is negotiated. Now, the short position, the farmer, begins to hurt since he would feel that his cocoa could now be sold at higher prices. He would regret having locked himself into the ‘low’ forward price. • We assume that the two parties had agreed on a forward price of RM100 per ton. We examine what will happen if say, the spot price on maturity day is at RM70 per ton or RM120 per ton.

  22. Advantages of futures contracts over forward contracts • Liquid market, lots of buyers and sellers at organized exchanges all over the world. • Active secondary market. Contract may trade hands many times before expiration. • Minimal risk. The futures exchange requires an initial margin to open a position and they enforce daily settlement of all gains and losses to avoid default. There is maximum price movement, called daily limit, to minimize large losses. For example, daily price limit for palm oil futures is 10% above or below the settlement price of the preceding business day, trading stops for the day.

  23. Advantages of futures contracts over forward contracts • The counterparty risk is reduced through a clearing house which take responsibility for ensuring the contract is brought through without any parties defaulting in the transaction. • Cash settlement for most futures contracts, instead of settlement in the actual commodity. • You can close your account anytime by taking an offsetting position. If your original position is to buy (go long) a futures contract, you can subsequently sell (go short) to close out your position, and vice versa. You can cash out without having to make or receive delivery.

  24. Disadvantages of futures contracts over forward contracts • Less flexible since futures contracts are for fixed, standard amounts, e.g. palm oil futures contracts are for 25 metric tons per contract. • Expiration dates are fixed: E.g. Jan, March, September and December. (only few delivery per year. • The location for delivery are fixed (Port Kelang, Penang/Butterworth and PasirGudang (Johor)

  25. Examples of futures contracts traded in Bursa Malaysia Derivatives Bhd • Stock Index Futures • KLCI (FKLI) Futures • Single Stock Futures (SSFs) • Interest Rate Futures • 3 Month Kuala Lumpur Interbank Offered Rate interest rate (FKB3) • Bond Futures • 3-Year Malaysian Government Securities (FMG3) Futures • 5-Year Malaysian Government Securities (FMG5) Futures • 10-Year Malaysian Government Securities (FMGA) Futures • Agriculture Futures • Crude Palm Oil (FCPO) Futures • Crude Palm Kernel Oil (FPKO) Futures • USD Crude Palm Oil (FUPO) Futures

  26. The Key Elements of Futures Trading • Convergence of Futures and Cash Prices • Basis and Basis Risk • Margins and Marking to Market • Types of orders • The Clearing House

  27. Price Convergence • The futures price of a contract and the cash price (spot price of the underlying) of the same commodity tend to converge, i.e. they will come together as the delivery month of the futures contract approaches. On maturity date, the futures price must equal spot price. • When futures price > spot price = contango. • When futures price < spot price = backwardation. • Determined by market forces (ss and dd)

  28. The Convergence Property • The convergence property states that the price of a futures contract on the day of its maturity must equal the spot price of the underlying on that day. • The logic for this is that, on its maturity day, a futures contract is essentially a spot asset. • The Spot Price and the Future Price must be equal otherwise there would be a riskless arbitrage opportunity. One could even argue that the existence of such arbitrage opportunity would ensure convergence.

  29. Spot-Futures Convergence at Maturity Spot/Futures Price Futures Spot t Maturity day

  30. Basis and Basis Risk • Basis is the difference between cash price (or spot price), S and Futures price, F. • It reduces to zero at it approaches maturity of the futures contract. • In a perfect hedge, the gains or losses in the futures contract exactly offset the losses or gains of the underlying asset being hedged. • If do not perfectly cancel each other out, it is called basis risk. Due to mismatches of quality (grade), location, maturity, qty.

  31. Basis and Basis Risk • The difference or spread between the futures and spot prices is often known as the basis. The basis should equal the net carrying cost. • The basis narrows over time to reach zero at maturity. Prior to maturity however, the basis would be positive or occasionally negative.

  32. Basis risk can be thought of as tracking error. Basis risk would be present whenever there is any of these three mismatches: (i) Asset mismatch (ii) Maturity mismatch and (iii) Quantity (or contract size) mismatch.

  33. Margins and Marking to Market • Example: Consider an investor, contacts his broker on Tuesday, 2nd of June to buy two December crude palm oil futures contracts at Bursa Malaysia Derivative Berhad. One futures contract equivalent to 25 metric tons. Current market price is RM2,000 per ton. Therefore, the investor is contracted to buy 50 metric tons at this price. The total value of this transaction: = 2 contracts x 25 metric tons x RM2,000 = RM100,000

  34. Margins and Marking to Market • The broker requires the investor to deposit some money in a margin account (initial margin). Assume that the initial deposit is RM10,000 per contract = Initial Margin = RM20,000. • At the end of each day, the margin account is adjusted to reflect the investor’s gain or loss. • This is the additional margin payments that would have to be paid and is called the variation / maintenance margin. • This practice is referred to as “marking to market” or (marked to market).

  35. Margins and Marking to Market • Assume that at the end of the day, the palm oil futures price closes at RM1,850 per ton. This implies that the investor has made a loss = 2 contract x 25 metric tons x RM150 = RM7,500 • If the price for the following day closes at RM2,300 per ton, the balance of the margin account will increase by: 2 x 25 x RM450 = RM22,500 • Hence for the last two days, the margin balance has become RM35 000 = (RM20,000 – RM7,500 + RM22,500) • The investor is entitled to withdraw any balance in the margin a/c in excess of the initial margin (IM) = RM15 000 • To ensure that margin a/c does not become negative, a maintenance marginis set (usually lower than IM). • If the balance falls < maintenance margin, the investor will receive a margin call. Heis expected to top up the difference back to the initial margin the following day.

  36. The Clearing House • Acts as intermediary in futures transactions. • Guarantees the performance of the parties in each transaction. • To ensure none of the parties are hurt by the defaulting party.

  37. Crude Palm Oil (FCPO) Futures and KLCI (FKLI) Futures • The Underlying Instrument of FCPO and FKLI • The Contract Specification FCPO – refer to Table 7.1 page 192 • The Contract Specification FKLI – refer to Table 7.3 page 196

  38. Trading Practicalities • Long – bought futures contract • Contract to receive delivery/contract to buy underlying asset • eg: Long 2 August 2011 FCPO at RM1000/tonne [ Engage in contact to receive delivery of 50 tonnes of CPO in August 2011 at RM1000/tonne] • Short – sell futures contract • Contract to make delivery/contract to sell underlying asset • Short 2 Aug 2011 at RM1000/t [ Engage in contract to deliver 50 tonnes of CPO in Aug 2011 at RM1000/t]

  39. EXERCISE • Long 3 Dec 2012 FCPO @RM1,200 • TODAY: • A contract to buy 75 tonnes of CPO in Dec 2012 at RM1,200 • At maturityDec 2012 • BUY 75 tonnes of CPO and pay RM1,200  Physical settlement • OR • SELL 3 Dec 2012 FCPO at price of Dec 2012 FCPO traded in Dec 2012.  cash settlement

  40. EXERCISE • Long August FKLI @ 1120 • Contract to buy KLCI in August @ 1120 • SETTLEMENT • CASH Settlement • Sell Aug FKLI @ price of AUG FKLI traded in Aug.

  41. Forwards, Futures; Zero sum Game • In a world of limited/finite resources, most financial transactions, including all derivatives transactions are zero-sum games; that is one party’s gain is at another party’s expense. if spot prices rise Profit to Long = Spot price at Maturity – Original Futures Price (the short position’s implied loss equals this amount) if spot prices fall Profit to Short = Original Futures Price – Spot price at Maturity. (the long position’s implied loss equals this amount)

  42. Types of Futures Markets Participants • Hedgers • Speculators • Arbitrageurs

  43. Hedgers • Futures traders who have a personal or business interest in the future commodity prices, exchange rate or interest rate. • E.g. importers/exporters, corporations buying and selling in the future, farmers, portfolio managers, firms expecting to borrow money in the future, firms/investors expecting to invest money in the future, etc.

  44. Hedgers - Examples • Farmers (sellers) and producers are worried about the price of their product going down in the future. They can use futures contract to lock in price now for future output of oil, corn, wheat, sugar, steel, gold etc by going SHORT on contracts for their product. • Exporters (importers) receiving foreign currency (paying in foreign currency) can hedge risk by going short (long) on currency futures.

  45. Given the KLCI is 1050 and the value of a portfolio is RM3 million. If the portfolio manager wishes to hedge 80% against a price decrease, how many contracts will the portfolio manager have to trade? Does the trader buy or sell? • Suppose in February, a palm oil producer anticipates that he will have 180 metric tonnes of crude palm oil ready for sale in four months’ time. He would like to fix the price for his produce. The current market price (February) of the palm oil is about RM2,250 per metric tonne while the June crude palm oil futures (FCPO)is currently trading at RM2,265.

  46. Types of Hedging • Hedging is taking a (1) future position in anticipation of a later cash transactionor (2) taking a future position opposite to the current physical position held. • The former type is known as anticipatory hedging and the latter type is known as hedging the current market position. • An example of anticipatory hedging is the palm oil producer who intends to sell his palm oil in 2 months could lock in the price by selling the futures contract today. • An example of hedging current market position is the fund manager with a portfolio of shares could hedge against a fall in share prices by selling (taking a futures position oppositeto the current position of holding a portfolio of shares) stock index futures contracts today.

  47. Strategy • Number of contracts • Contract Month • Action

  48. Types of Hedging • anticipatory hedging • - Refer to Table 7.5 page 199 • hedging the current market position

  49. An Anticipatory Hedge • Often, producers may not have an immediate position in an underlying asset but a potential position. That is, they anticipate having a position in the underlying asset at a future point. • Assume that the farmer is expecting to produce 120 tons of cocoa in 6 months and wishes to hedge his price-risk. Suppose further that cocoa futures are maturing in 6 months from now and have a standard size of 10 tons per contract. The current quoted price for 6 month cocoa is say RM100 per ton or RM1,000 per contract. For simplicity, assume that the confectioner also requires 120 tons in six months • Notice that the cocoa farmer in our example did not have an immediate exposure. He is expecting to harvest cocoa in 6 months. Yet, he hedges the position today. This is what is known as anticipatory hedge.

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