CHAPTER 7

FUTURES DERIVATIVES
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 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

2
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)

3
What is a derivative?
A derivative is a security with a price that is dependent
upon or derived from one or more underlying assets.
The derivative itself is a contract between two or more
parties based upon the asset or assets. Its value is
determined by fluctuations in the underlying asset.
The underlying can be share prices, prices of commodity,
indices and interest rates.
The value of the underlying assets changes every now
and then.

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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.

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 WHAT IS THE USE OF
DERIVATIVES Arbitrage is
simultaneous purchase
the

and sale of an asset in

order to profit from a
difference in the price. It
is a trade that profits by
exploiting price
differences of identical
or similar financial
instruments, on different
markets or in different
forms

Hedging against investment risk means strategically using

instruments in the market to offset the risk of any adverse price
movements. In other words, investors hedge one investment by
making another.

7
WHO ARE THE
PARTICIPANTS IN
DERIVATIVES MARKETS

8
 WHAT ARE THE DIFFERENT
TYPES OF DERIVATIVE
CONTRACTS
Futures are financial contracts
obligating the buyer to
purchase an asset (or the
seller to sell an asset), such
as a physical commodity or a
financial instrument, at a
predetermined future date and
price.
An option is a financial derivative
that represents a contract sold by
one party (option writer) to another
party (option holder). The contract
offers the buyer the right, but not
the obligation, to buy (call) or sell
(put) a security or other
financial asset at an agreed-upon
price (the strike price) during a
certain period of time or on a
specific date (exercise date).
A forward contract is a
customized contract between
two parties to buy or sell an
asset at a specified price on a
future date. Unlike standard
futures contracts, a forward
contract can be customized to
any commodity, amount and
delivery date. A forward contract
settlement can occur on a cash
or delivery basis. Not traded on
stock exchnage
A swap is a derivative contract
through which two
parties exchange financial
instruments. These instruments
can be almost anything, but most
swaps involve cash flows based
on a notional principal amount
that both parties agree to.
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SPOT MARKET vs
FORWARD/FUTURES
MARKETS
Also called the cash market or the physical market, the spot market is
where assets are sold forcash and delivered immediately.
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.
A futures market is an auction market in which participants buy and
sell commodity and futures contracts for delivery on a specified future
date.
Futures contracts are made in attempt by producers and suppliers of
commodities to avoid market volatility. These producers and suppliers
negotiate contracts with an investor who agrees to take on both the risk
and reward of a volatile market.

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FORWARD CONTRACT
A forward contract is a customized contract between two parties to buy
or sell an asset at a specified price on a future date. They are private
agreements withterms that may vary from contract to contract.
Unlike standard futurescontracts, a forward contract can be customized
to any commodity, amount and delivery date. A forward contract
settlement can occur on a cash or delivery basis.
Forward contracts do not trade on a centralized exchange and are
therefore regarded as over-the-counter (OTC) instruments. No
secondary market.
The lack of a centralized clearinghouse also gives rise to a higher
degree of default risk. As a result, forward contracts are not as easily
available to the retail investor as futures contracts

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FORWARD CONTRACTS
EXAMPLE

1
If you plan to grow 500 bushels of wheat next year, you could sell your wheat for
whatever the price is when you harvest it, or you could lock in a price now by
selling a forward contract that obligates you to sell 500 bushels of wheat to, say,
Kellogg after the harvest for a fixed price. By locking in the price now, you
eliminate the risk of falling wheat prices. On the other hand, if prices rise later,
you will get only what your contract entitles you to.
Advantage: buyer (company) and seller (farmer) gave a guaranteed price. They
are now protected from price swings in rice.
If you are Kellogg, you might want to purchase a forward contract to lock in
prices and control your costs. However, you might end up overpaying or
(hopefully) underpaying for the wheat depending on the market price when you
take delivery of the wheat.
It can be cash settled. For example, if the price of 500 bushels of wheat is
$1,000 in the spot market when the forward contract expires, but the forward
contract price is $800, then the seller can just settle the contract by paying the
buyer $200 instead of actually delivering 500 bushels of wheat and collecting a
below-market price. The seller then can sell his commodity in the spot market at
spot price

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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.

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What is a futures contract?
A futures contract is a contractual agreement, generally made on the
trading floor of a futures exchange, to buy or sell a particularcommodity
or financial instrument at a pre-determined price in the future.
Futures contracts detail the quality and quantity of the underlying asset;
delivery date (or the expiry date) and location of delivery. They are
standardized to facilitate trading on a futures exchange.
Some futures contracts may call for physical delivery of the asset, while
others are settled in cash.
Basically to overcome 3 problems of forward contract
(1) multiple coincidence needs,
(2) unfair forward price and
(3) counterparty risk.

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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.

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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.

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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 Pasir Gudang (Johor)

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Crude Palm Oil Futures (FCPO)
Contract Specification

Contract Code FCPO

Underlying Instrument Crude Palm Oil

Contract Size 25 metric tons

Minimum Price RM1 per metric ton
Fluctuation

Daily Price Limits With the exception of trades in the spot month, trades for
future delivery of Crude Palm Oil in any month shall not
be made, during any one Business Day, at prices varying
more than 10% above or below the settlement prices of
the preceding Business Day ("the 10% Limit") except as
provided below.

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Contract Months Spot month and the next 5 succeeding months, and thereafter, alternate
months up to 24 months ahead
Trading Hours First trading session: Malaysian time 10:30 a.m. to 12:30 p.m.
Second trading session: Malaysian time 3:00 p.m. to 6:00 p.m.
Final Trading Day and Contract expires at noon on the 15th day of the delivery month, or if the
Maturity Date 15th is a non-market day, the preceding Business Day.
Tender Period 1st Calender Day to the 20th Calender Day of the spot month, or if the 20th
is a non- market day, the preceding Business Day.
Contract Grade and Delivery Crude Palm Oil of good merchantable quality, in bulk, unbleached, in Port
Points Tank Installations approved by the Exchange located at the option of the
seller at Port Kelang, Penang/Butterworth and Pasir Gudang (Johor).Free
Fatty Acids (FFA) of palm oil delivered into Port Tank Installations shall not
exceed 4% and from Port Tank Installations shall not exceed 5%.
Moisture and impurities shall not exceed 0.25%.
Deterioration of Bleachability Index (DOBI) value of palm oil delivered into
Port Tank Installations shall be at a minimum of 2.5 and of palm oil
delivered from Port Tank Installations shall be at a minimum of 2.31.
Deliverable Unit a.25 metric tons, plus or minus not more than 2%.

Settlement of weight differences shall be based on the simple average of

the daily Settlement Prices of the delivery month from:The 1st Business
Day of the delivery month to the day of tender, if the tender is made before
the last trading day of the delivery month; or
b.The 1st Business Day of the delivery month to the last day of trading, if
the tender is made on the last trading day or thereafter

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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

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The Key Elements of Futures Trading

Convergence of Futures and Cash /spot

Prices
Basis and Basis Risk
Margins and Marking to Market
Types of orders
The Clearing House

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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)

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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.

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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

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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 investors 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).

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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 RM300 = RM15,000
Hence for the last two days, the margin balance has become
RM27,500 = (RM20,000 RM7,500 + RM15,000)
The investor is entitled to withdraw any balance in the margin a/c
in excess of the initial margin (IM) = RM7,500
To ensure that margin a/c does not become negative, a
maintenance margin is set (usually lower than IM).
If the balance falls < maintenance margin, the investor will
receive a margin call. He is expected to top up the difference
back to the initial margin the following day.

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day Futures Daily gain Cumulative Margin ac Margin call
price (loss) gain (loss) balance
2000 20000
June 2 1850 (7500) (7500) 12500 -
June 3 2300 2250 15000 27500

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Illustration
An investor contact his brokeron June 5 to buy two Dec gold futures
contract on NY Commodity Exchange (COMEX). Suppose current futures
price is $400 per oz. Contract size is 100 oz. the broker will require the
investor to deposit funds in a margin account. The amount is known as
initial margin.
Suppose by end of June 5, the price has dropped to 397. the investor
has a loss of 600 (200oz x 3). The balance in margin account would
therefore reduced by 600 to 3400.

At the end of each trading day the margin account is adjusted to

reflect the investors gain or loss is referred to as marking to market.

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Suppose initial margin is 2000 per contract and
maintenance margin is 1500 per contract

day Futures Daily gain Cumulative Margin Margin call

price (loss) gain (loss) account
balance
400 4000

June 5 397 (600) (600) 3400

6 396.1 (180) (780) 3220
9 398.2 420 (360) 3640
10 397.1 (220) (580) 3420
11 396.7 (80) (660) 3340
12 395.4 (260) (920) 3080
13 393.3 (420) (1340) 2660 1340 Extra Funds
deposited is called
variation margin

16 393.6 60 (1280) 4060

17 391.8 (360) (1640) 3700 29
Types of Futures Markets
Participants
Hedgers
Speculators
Arbitrageurs

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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.

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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.

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Types of Hedging
1) taking a future position in anticipation of a later cash
transaction or anticipatory hedging nti
2) taking a future position opposite to the current physical
position held or 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
opposite to the current position of holding a portfolio of
shares) stock index futures contracts today.

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Advantages and
disadvantages of trading
futures contract
Please prepare your own notes from page

187 text book.

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SPECULATORS
Have no personal or business interest in the
commodity or currency. They are trading futures
contracts as a purely speculative investment or
gamble.
For example, an investor could take a position on a
palm oil futures contract for March 2009 @ RM1,250
per metric ton, and they are not in the palm oil
business, they have no interest in actually receiving or
delivering palm oil at expiration. They are just taking a
position on the price of palm oil in the future.
Speculators can participate in futures trading because
actual delivery is not required.

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SPECULATORS -
EXAMPLE
If a speculator thinks that the cash price of

palm oil will go above RM1,250 sometime

between now and June 2009, they take a
LONG POSITION, and buy palm oil futures
contracts. They are speculating that the
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.
36
SPECULATORS -
EXAMPLE
If the speculator thinks that the cash price of
palm oil will go below RM1,250/metric ton,
he will take a SHORT POSITION, and sell
palm oil futures. He will make money if
P < RM1,250, they are betting that the price
of palm oil will fall.

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Speculating with Futures Contract
Speculators deal with price changes that
occurred in the market.
They are motivated by the strong desire to make
profit on the transaction.
They will buy the futures at low price and sell at
high price.
The speculative traders in the futures market
help to fulfil a very important role. They provide
the depth and volume of trading that allow
hedgers and others to enter or exit the market
easily.

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Three types of speculators
The scalpers look out for minimum price fluctuations
on heavy (large) volumes taking small profits at a time.
They aim to make small profits on large volumes of
transaction.
The day traders do intraday trading and on small
volumes of trade. The typical day trader would take
long or short positions of a few contracts and would
close-out their positions later in the day when the
prices have moved.
The position traders look for long-term price trends
and may hold over weeks, or months before getting
out.

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Arbitraging with Futures Contract
Arbitrage is simultaneous purchase and sale of the
same instrument in different markets to profit from the
temporary price differences or inconsistencies.
How did arbitrage ensure price convergence?
An arbitrage is a trade that involves buying in the
physical market and selling at the futures market at a
higher price.
A trader who initiate the arbitrage on observing the
prices are traded above the fair values will act on by
selling the futures where the prices are high and
pushes the price back (create supply) to the fair value
as determined in the physical market.
Provide liquidity and ensuring the price of cash and
futures converges at the expiry date of the contract.
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Fair value of futures price using cost of carry model

Fair value of futures is equivalent to the current price of the underlying

assets plus carrying charges

where
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
opportunity cost)
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

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Fair value of futures price using
cost of carry model
Example:
Please refer to example in text book page
190

42
 Types of order (please read the
following from your text book)
Market order
Limit order
Stop order or stop loss.

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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.

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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

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Using CPO Futures to Hedge

A crude palm oil producer selling hedge or

doing anticipatory hedging
- Refer to Table 7.5 page 199
A crude palm oil refiner buying hedge or
doing hedging the current market position
- Refer to Table 7.6 page 201

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Selling Hedge - Example
Suppose in Feb, a crude palm oil producer anticipates
that he will have 200 metric tons of crude palm oil
ready for sale in two months time. He would like to lock
in the price of his crude palm oil. The current mkt price
(Feb) is RM1,250 per metric ton. April crude palm oil
futures is currently trading at RM1,265.
His exposure to risk = price may fall between now
(Feb) and the time of sale (April) = risk of price decline.
Action: Sell futures (short position) of a specific
number of contracts at a certain point in future
= 200 tons/25 = 8 contracts

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Selling Hedge - Example
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).
The producer sells the CPO in the spot market for
RM1,245 and also closes out the futures position
by buying (long position) 8 futures contracts at
RM1,245.

48
Summary of the positions:
Position Today Position at Maturity Gains/Loss

Cash Mkt Mkt price = RM1,250/ton Mkt price = RM1,245

Action: sells 200 tons at
RM1,245.
Total sales = 200 x
RM1,245 = RM249,000 RM249,000
Futures Mkt Mkt price = RM1,265/tone Close its position by
Action: short futures buying 8 futures contract
= 8 contracts at RM1,265 @RM1,245.
Total value of futures Action: Long Futures
= 8 x 25 x RM1,265 = 8 x 25 x RM1,245
= RM253,000 = RM249,000 RM4,000

Total revenue RM253,000

Effective price per metric RM1,265

ton RM253,000
200 tons
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Buying Hedge - Example
Suppose in May, a crude palm oil refiner receives an order
for a 800 met tons of refined PO to be delivered in Sept. He
would like to lock in the price of his crude palm oil. The
CPO futures for delivery in Sept is trading at RM1,270.
Current spot price = RM1,265 (lower than futures price).
However he does not have the available cash to buy now.
His exposure to risk = price may increase in the future.
Action: Buy futures (long position) of a specific number of
contracts at a certain point in future
= 800 tons/25 = 32 CPO Sept futures contracts at
RM1,270.
(he needs to pay only the initial margin)
This gives confidence to the oil refiner to quote the price to
his customers using known PO cost.
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Buying Hedge - Example
In Sept, he purchases the 800 met tons of CPO in
the spot market at RM1,278
He closes out the futures position by selling (short
position) 32 futures contracts at the current mkt
price of RM1,278.

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Summary of the positions:
Position Today Position at Maturity Gains/Loss
Cash Mkt Mkt price = RM1,265 Mkt price = RM1,278
The refiner needs 800 met Action: buys 800 tons
tons of CPO in Sept. at RM1,278.
Total costs:
= 800 x RM1,278
= RM1,022,400 (RM1,022,400)
Futures Mkt Mkt price = RM1,270 Close its position by
Action: buy futures selling 32 futures
= 32 contracts at RM1,270 contract @RM1,278.
Total value of futures Action: sell Futures
= 32 x 25 x RM1,270 = 32 x 25 x RM1,278
= (RM1,016,000) = RM1,022,400 RM6,400 (Pft)
Net costs (RM1,016,000)
Effective price per RM1,270
metric ton (RM1,016,000)
800 tons

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Using CPO Futures to Speculate

Outright position speculative strategy

Takes a view of the change of the futures prices
and speculate on it
refer to section 7.5.4.1 page 202

Spread trading speculative strategy

Based on expectations of changes in relationship
between several futures contract
refer to section 7.5.4.2 page 203

53
Using CPO Futures to Arbitrage

Find the fair value of the futures price

If the actual futures price > fair value, overpriced
position sell futures and buy the spot or physical
market
If the actual futures price < fair value, underpriced
position buy futures and sell the spot or physical
market
An illustration of how to calculate fair value of the
CPO futures page 204
Table 7.7 shows the outcome of arbitraging.

54
Using KLCI Futures to Hedge

A portfolio manager buying hedge or doing

anticipatory hedging
- Refer to Table 7.8 page 207
A portfolio manager selling hedge or doing
hedging the current market position
- Refer to Table 7.9 page 208

55
Using KLCI Futures to Speculate

Outright position speculative strategy

Takes a view of the change of the futures prices
and speculate on it
refer to section 7.5.7.1 page 209

Spread trading speculative strategy

Based on expectations of changes in relationship
between several futures contract
refer to section 7.5.7.2 page 210

56
Using KLCI Futures to Arbitrage

Find the fair value of the futures price

If the actual futures price > fair value,
overpriced position sell futures and buy
the spot market
If the actual futures price < fair value,
underpriced position buy futures and sell
the spot market
An illustration of how to calculate fair value
of the KLCI futures page 211
57
Single Stock Futures (SSFs)

SSFs are based on individual stocks listed in

Bursa Malaysia and therefore, it tracks the
movement of the individual underlying stock.
As of now, there are 9 SSF contracts.
The contract specification refer to Table
7.10 page 213.

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