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
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.
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.
Confection (Long Position)
Agree on :
Price, quantity, quality, maturity delivery location etc.
Step 2 (on maturity date; day = 180)
Confection (Long Position)
The long position agrees to take delivery (buy) of the underlying asset while the short position agrees to make delivery (sell).
(i) asset match
(ii) maturity match
(iii) quantity match
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.
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.
(i) Asset mismatch
(ii) Maturity mismatch and
(iii) Quantity (or contract size) mismatch.
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
2 x 25 x RM450 = RM22,500
[ Engage in contact to receive delivery of 50 tonnes of CPO in August 2011 at RM1000/tonne]
[ Engage in contract to deliver 50 tonnes of CPO in Aug 2011 at RM1000/t]
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)
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?
(3) w. receipt
(3) w. receipt
Numbers within brackets show the sequence of events
Assume in April the price of crude palm oil in the spot market has dropped to RM1,245/ton. So has the April futures (price convergence).
P > RM1,250, and will make money if that happens. They buy @RM1,250 and hope to sell at P > RM1,250. Speculator is gambling (betting) that the price of palm oil will be > RM1,250.
P < RM1,250, they are betting that the price of palm oil will fall.
Spread 70 points
F = futures price for a contract with maturity from time t to T at maturity
S = cash or spot price of the underlying asset
r = annualised risk-free interest rate (a proxy for
c = annualised cost of storage (%) (inclusive of shipping, handling, shrinkage, spoilage or damaged, etc)
y = convenience yield on the cash commodity
t = time to futures expiry expressed on yearly basis
F = RM1,275 (1 + 0.04 + 5x12/1,275) 30/365
Is it possible to make a gain if the actual futures price is lower than the fair price? If so, describe the strategy a trader could use in this situation.
= 983.51 FV April FCPO
[ April FCPO should trade above this limit]
Sell April FCPO at RM1000/t coz overvalue
Buy CPO at RM975/t; store at RM5 per month.
Upon maturity, deliver CPO to buyer and receive RM1000/t.
Profit: 1000 – 975 – 5 = RM20/t
F = 994.90
Today: Sell 94 Nov FKLI @ 1060
Buy RM5 million shares @ 990. Hold temporarily
Later: Buy 94 Nov FKLI @ 1020
Sell shares that worth
( 5M + ( 1020-990/990)5M= 5151515.152
= 1,200 (1.02)0.25
= 1,205.96 points
Since there is mispricing, arbitrage is possible. By using the following arbitrage strategy a riskless profit can be made. (Note that no cash outlay is needed today
we will look at 2 market scenarios. (Note: current stock index value is 1,200 pts)
Now, the SIF is underpriced relative to spot. In order to arbitrage we need to do the reverse of the earlier strategy
The following reverse Cash and Carry arbitrage would be appropriate here