Chapter_8

DERIVATIVES MARKET

DERIVATIVES MARKETCHAPTER 81ObjectivesDefinition and purpose of derivatives marketDerivative instrumentsExchange-traded versus over the-counter derivativesMarket players and institutions

2IntroductionTransactions in the market:Spot transactionsDelivery happens on the spotForward transactionsDelivery happens sometimes in the future but the price and quantities are determined today

3IntroductionDerivatives are instruments created to minimize riskTheir value are derived from somethingFrom an assetExample: share prices, prices of commodity, indices and interest ratesCommodity derivative if the underlying assets are commodities such as palm oil, coffee, wheat etc.Financial derivative if the underlying assets are financial assets such as debt instruments, currency, share price etc.

4IntroductionDefinition:Derivative instruments are simply financial instruments which have values determined by prices of the underlying assetsTheir values depend on prices of underlying assets3 main derivative instruments:Futures ForwardsOptions 5History of DerivativesStarted as early as 1848 in the USMainly concentrated in the commodity market1919 the establishment of Chicago Mercantile Exchange (CME), providing futures contract on various commoditiesLater, New York Mercantile Exchange and Chicago Board Options Exchange were developedFinancial derivatives began to dominate trading during the 1970sIn the early 1980s, most of the financial futures were traded in USBut later, in the mid1980s to 2003, new exchanges were developed throughout Europe, South America and Asia Pacific region6The link between the development of derivatives market and price variability of financial instruments is naturalA need to manage the risk 7History of DerivativesThe Development of Malaysian Derivatives MarketFrom 1980 1995, our derivatives market was confined mainly on the crude palm oil (CPO) futures traded on the Kuala Lumpur Commodity Exchange (KLCE)In 1995 Kuala Lumpur Options and Financial Futures Exchange (KLOFFE), now known as Bursa Malaysia Derivatives Berhad (BMD) which is 75% owned subsidiary of Bursa Malaysia Berhad. 25% owned by CME. It provides, operates and maintains a futures and options exchange.BMD operates the most liquid and successful crude palm oil futures contract in the worldOn 15 Dec 1995, the first financial futures contract based on the KLSE CI was traded on KLOFFE8May 1996 Malaysia Monetary Exchange (MME) was set up to provide fixed income derivatives, namely 3-month KLIBOR futures contractIn 1998 KLCE + MME = COMMEX (Commodity and Monetary Exchange of Malaysia)Jan 1999 KLOFFE became the subsidiary of KLSEJune 2001 KLOFFE + COMMEX = Malaysian Derivatives Exchange (MDEX)MDEX was renamed Bursa Malaysia Derivatives Berhad on 20 April 20049The Development of Malaysian Derivatives MarketBMD operates under the supervision of SC and is governed by the Capital Market and Services Act 2007On September 17, 2009, BMD entered into a strategic partnership with Chicago Mercantile Exchange10The Development of Malaysian Derivatives MarketDerivative Products Traded on BMDhttp://www.bursamalaysia.com/market/derivatives/

BMD has the following products available to be traded on the CME Globex electronic trading platform

Commodity DerivativesCrude Palm Oil Futures (FCPO) USD Crude Palm Oil Futures (FUPO) Crude Palm Kernel Oil Futures (FPKO)

Equity DerivativesFTSE Bursa Malaysia KLCI Futures (FKLI) FTSE Bursa Malaysia KLCI Options (OKLI) Single Stock Futures (SSFs)

Financial Derivatives3 Month Kuala Lumpur Interbank Offered Rate Futures (FKB3) 3-Year Malaysian Government Securities Futures (FMG3) 5-Year Malaysian Government Securities Futures (FMG5)

11Forward and Futures ContractsForward ContractA contract between two parties agreeing to carry out a transaction at a future date but a price determined todaySteps involved in buying crude palm oil:Setting the price to be paid, exact specification of quality, quantity and delivery logistics, such as time, date and placeDelivering the crude palm oil from seller to buyerPayment of cash from buyer to sellerHow does the forward contract work?

12Time to settle the contract in the future expiration dateExample: a rice farmerHow long does it take to harvest the paddy?Price riskWhat is the price risk for the farmer?What is the price risk for the producer?Since both are facing the price risk, a forward contract can help them eliminating the price risk. How?A seller short positionA buyer long position13Forward and Futures ContractsFutures ContractTo overcome 3 problems of forward contracts:Multiple coincidence needsMatch the underlying asset, delivery date or maturity and specified quantityUnfair forward priceThe party who has better negotiating power may dictate unfair priceCounterparty riskOne party may default which create losses to the other party14Forward and Futures ContractsFutures contractAn exchange-traded form of forward contractA commitment to buy or sell an underlying asset at a future dateContracts are standardizedExcept for price - quantity, quality of the underlying asset, deliver date and location of deliveryTraded electronicallyThe price is determined based on the interaction between many buyers and sellersThe counterparty risk is reduced through a clearing houseGuarantees the performance of the parties in each transaction

15Forward and Futures ContractsHedging, Speculating and Arbitraging with Futures ContractsHedging with FuturesThe profitability of most individuals and corporations is affected by the changing prices of commodities and financial instrumentsRisk of price fluctuations (price risk)Futures markets provide a means of cancelling out the exposure to drastic price fluctuations in the underlying or physical marketThe purpose of hedging to preserve the wealth16Hedging Taking a future position in anticipation of a later cash transaction (anticipatory hedging) or Example: the palm oil producer who intends to sell his palm oil in two months could lock in the price by selling the futures contract todayIf the future price of the palm oil decreases, .The basic idea of hedging is to establish an opposite position in futures so that the gain from the futures position cancels out the loss from the underlying or physical market position17Hedging, Speculating and Arbitraging with Futures ContractsTaking a future position opposite to the current physical position held (hedging the current market position)Example: a fund manager with a portfolio of shares could hedge against a fall in share prices by selling stock index futures contract todayWhen the fund manager locks in the price, if the future price of the index drops, the decline or loss in portfolio value is compensated by the gain from the futures position

18Hedging, Speculating and Arbitraging with Futures ContractsHow do we determine when we should buy (long) or sell (short) a futures contract?2 ways:To observe the hedge from the underlying positionTo observe from the point of price risk. To protect from the rising prices, the trader should buy the futures contract. To protect against falling prices, the trader should sell the futures contract.19Hedging, Speculating and Arbitraging with Futures ContractsAdvantages of trading futures contracts:The minimum margin requirements allow traders to leverage their investments, that is, to trade many times more than the original cost of investmentA futures contract does not have to be held till it expires or matures. It can be closed out before the contract expires by making an opposite transactionLow transaction costs20Hedging, Speculating and Arbitraging with Futures ContractsDisadvantages of trading futures contract:The futures contracts are standardizedMay prevent the hedger from benefiting from favorable price movements21Hedging, Speculating and Arbitraging with Futures ContractsSpeculating with FuturesDeal with price changes that occur in the marketTry to make profit. Example: buy futures at a low price, then sell it at a high priceAn important role: provide the depth and volume of trading that allows hedgers and others to enter or exit the market easilyProvide liquidity and continuous trading22Hedging, Speculating and Arbitraging with Futures ContractsArbitraging with FuturesArbitrage in the practice of taking advantage of price differentials across different marketsSimultaneous purchase and sale of the same instrument in different markets to profit from the temporary price differences Example: currency tradingArbitrageurs also play an important role in providing liquidity and by ensuring the price of cash and futures converges at the expiry date of the contract23Hedging, Speculating and Arbitraging with Futures ContractsOptions derivativesIt is a contract between a buyer (option buyer) and seller (option seller) in which the buyer of the option has the right but not the obligation, to buy or sell a certain asset at a certain price before a certain date.What is the difference between the right and obligation?24Selling an option (writing an option) versus buying an option (take)The option seller is obligated to perform according to the terms of the contract once the option buyer exercises the option

25Options derivativesDifference between options and futuresRight versus obligationRisk of loss is carried by the option sellerThe option buyer is protected from unfavorable market movementsFulfillment of the contractFutures both parties are obliged to transact at the same specified time in the futureoption only one party is obliged to transact, when the buyer exercising the option.26Options derivativesAdvantages of options:Limited risk (applicable to buyers only)Option sellers have unlimited risk similar to future holdersFlexibilityStandard options provide flexibility to trade freely in the open marketImproves liquidity and allowing prices to be more accurately priced27Options derivativesExchange-traded optionsOriginate and traded on a formal exchangeMost commonly are equity optionsTraded using electronic trading systemsSettled through a clearing house (MDCH)NovationA process whereby it connects the two contracting partiesStandardized except for the priceOver-the-counter optionsNot traded through a formal exchangeArrange deals through telephone or on face-to-face meetingsAble to negotiate as to quantity, quality maturity and deliveryHigher credit risk28Options derivativesUses of OptionsInvestment in options provides leveragePurchase of option requires only payment of the premium which is usually a small percentage of the price of the underlying assetWhat about investment in shares?Options can be used extensively in risk managementHedgingThe use of call and put options in the situation of rising and falling pricesTo enhance portfolio returnsHaving some shares may allow an investor to sell call options to others to earn premium29Options are very flexible financial instrumentsCan be used to create strategies to take advantage of different situationsOptions are used to manage information asymmetryA situation where both parties to the transaction do not have equal access to market informationAttach put options with IPO30Uses of OptionsExamples of options traded on exchangesKuala Lumpur Composite Index Options (OKLI)SGX MSCI Singapore (SiMSCI) OptionsSGX Nikkei 225 Index OptionsSGX Eurodollar OptionsKOSPI 200 OptionUS Dollar OptionHang Seng Index Options31The Key Elements of an OptionTypes of OptionsCall OptionA call option gives the option buyer the right (but not the obligation) to buy a specified asset at a specified price at or before a specified date.When the option buyer exercises the right, the option seller is obliged to sell the asset to the option buyer.Put OptionA put option gives the option buyer the right (but not the obligation) to sell a specified asset at a specified price at or before a specified date.When the option buyer exercises the right, the option seller is obliged to buy the asset from the option buyer.32Underlying assetsShares, an index, a particular futures contract, currencies, gold etc.An index represents what?33The Key Elements of an OptionStrike price or exercise priceIt is an agreed price at which the underlying asset is transacted if the option is exercisedThe buyer will only exercise the option when circumstances favour itIf the strike price is more favourable than the prevailing price, such an option is described as in-the-moneySo, when does a call option is described as in-the-money?When does a put option is described as in-the-money?34The Key Elements of an OptionAn option is said to be at-the-money if the exercise price equals the spot price of the underlying assetIf this kind option is exercised, zero profit on exercise and loss on the price paid for the option (premium)An option price is said to be out-of-money is the exercise price is higher than the price of the call options underlying assetWhat about a put option? When does it considered as out-of-money?For out-of-money, the option will not be exercised.35The Key Elements of an OptionExpiry date and option styleExpiry date is the maturity dateTwo types of option stylesAmerican style optionCan be exercised at any timeEuropean style optionCan be exercised only on the specified expiry date

36The Key Elements of an OptionPremium Cost or the price of an optionThe price that the option buyer pays to the option sellerPremiums are quoted as index points to one decimal placeExample: 1 point for RM100, 0.1 for RM10. If the premium is 25 points, then the price of the option is RM2,500.37The Key Elements of an OptionPremium is quoted based on the sum of intrinsic value and time valueIntrinsic value is the profit that can be obtained on an immediate exerciseIntrinsic value equals the amount where option is in-the-moneyThe option of at-the-money and out-of-money has zero intrinsic value

38The Key Elements of an Option39

Potential Gains or Losses on a Call Option: Exercise Price = $115, Premium = $440

Potential Gains or Losses on a Put Option: Exercise Price = $110, Premium = $2SwapsSwaps are customized bilateral transactions in which the parties agree to exchange cash flows at fixed periodic intervals, based on the underlying asset.Over-the-counter instrumentCan be 1 month, 3 months, 6 months etcEach side of swap is called a legInterest rate swaps41SwapsExample:Let say Fair Ltd borrows RM50 million at a floating interest rate of KLIBOR plus a credit spread of 0.5% payable in 5 years. Meanwhile, Adil Ltd borrows RM50 million at a fixed interest rate of 9% payable also in 5 years.Fair Ltd and Adil Ltd may agree to swap their liabilities whereby Fair will pay Adil a fixed interest of 9% and Adil will pay Fair a floating rate of KLIBOR plus 0.5%.Companies involved in the swap agreements are known as counterparties.42Swaps43

Illustration of an Interest Rate Swap to Reconfigure Bond PaymentsSwaps44