Chapter 5, DERIVATIVES MARKET

8/7/2019 Chapter 5, DERIVATIVES MARKET

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DERIVATIVE MARKETS Derivatives :

Financial contracts whose values are derived from the value of

underlying instruments (commodity prices, interest rates,indices, share prices).

Can be traded in an organized exchange or over-the-counter.

Financial instruments used to manage ones exposure to todaysvolatile market.

Objectives : speculation, reduce portfolio risk.

Instruments : forward, futures, options


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Forward contracts an agreement between 2 counterparties that fixes the

terms of an exchange that will take place between them at

some future date

A contract forforward delivery.

The contract specifies : whatis being exchange,

the price at which the exchange takes place, the date in thefuture at which the exchange takes place


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Forward contract is a tailor-made contract.

Cannot be cancelled without the agreement of bothparties.

Not liquid/marketable.

No guarantee that one party will not default.

Traded OTC


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Futures contracts an agreement between 2 counterparties to buy or sell the

underlying instrument at a specific time in the future for aspecific price determined today.

Different from forward.

Standardized agreement to exchange specific types ofgood, in specific amounts & at specific futuredelivery/maturity dates.

Traded on the exchange


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Example:

A futures contract for the purchase of 1,000 ounces of silver at $7per ounce.

The contract specifies that the buyer of the contract, the longposition, will pay $7,000 in exchange for 1,000 ounces of silver.

The seller of the contract, the short position, receives the $7,000 anddelivers the 1,000 ounces of silver.

If the price rise to $8 per ounce, the seller needs to give the buyer

$1,000 (margin account of the seller will be debited) so that thebuyer pays only $7,000.

If the price falls to $6 per ounce, the buyer needs to pay $1,000 tothe seller to make sure the seller receives $7,000.


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Buyer of a Futures Contract Seller of a Futures Contract

This is called the: Long position Short position

Obligation of the party: Buy the commodity / asset on

the settlement date

Deliver the commodity / asset

on the settlement date

What happens to this persons

margin account after a rise in

the market price of the

commodity or asset?

Credited Debited

Who takes this position to

hedge?

The user of the commodity or

buyer of the asset who needsto insure against the price

rising

The producer of the

commodity or owner of theasset who needs to insure

against the price falling

Who takes this position to

speculate?

Someone who believes that


commodity or asset will rise

Someone who believes that


commodity or asset will fall


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OPTIONSLike futures, options are agreements between two

parties.

Seller = option writer

Buyer = option holder

Options transfer risk from the buyer to the seller,

so they can be used for both hedging and

speculation.


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Options contracts

an option gives to its holder the right but not the

obligation to buy or sell a certain quantityunderlying security at a fixed price (exercise price/

strike price) at or before a specific date (the

maturity date/ expiry date by paying a premium.


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A call option a right to buy a given quantity of anunderlying asset at a predetermined price, called

the strike price (or exercise price), on or before a

specified date.

A March 2010 call option on 100 shares of I0I

Corp stock at a strike price of 9.

- the option holderthe rightto buy 100 shares ofI0I for RM9 apiece prior to the third Friday of

March 2010.


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- The holder has the option to buy and will do so onlyif buying is beneficial.

- Whenever the price of the stock is above the

strike price of the call option, exercising the option isprofitable for the holder, and the option is said to be inthe money.

- The writerof the call option must selltheshares if and when the holder chooses to use the calloption.


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A put option a right to sell the underlying asset at a

predetermined price on or before a fixed date.

The writer of the option is obliged to buy the shares

should the holder choose to exercise the option.

A March 2010 put option on 100 shares of I0I Corp stock

at a strike price of 9.

- a right to sell 100 shares at RM9 per share

- valuable when the market price of IOI stock falls

below RM9.


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Two types of call and put:

1. American options

can be exercised on any date from the time theyare written until the day they expire.

2. European optionscan be exercised only on the day that they are

expire.


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Calls Puts

Buyer Right to buy the

underlying asset at the

strike price prior to or on

the expiration date

Right to sell the underlying

asset at the fixed price

prior to or on the

expiration date

Seller Obligation to sell the


strike price

Obligation to buy the


strike price

Option is in the money

when.

Price of underlying asset is

above the strike price

Price of underlying asset is

below the strike price

Who buys one Someone who:

-Wants to buy an asset in

the future and insure the

price paid will not rise

Someone who:

- Wants to sell an asset in

the future an insure the

price paid will not fall


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Calls Puts

Who buys one - Wants to bet that the

price of the underlyingasset will rise

- Wants to bet the the price

of the underlying asset willfall

Who sells one to speculate Someone who

-Wants to bet that the

market price of the

underlying asset will not

rise

Someone who

- Wants to bet that the

market price of the

underlying asset will not

fall


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Instruments KLCI Futures

KLCI Options

3 month KLIBOR futures Crude Palm Oil Futures (CPO)

3-year MGS Futures

5-year MGS Futures

10-year MGS Futures Crude Palm Kernel Oil Futures (FPKO)

Single Stock Futures

Ethylene OTC Futures Contract


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Example of instrument

Three Month KLIBOR Futures:

An interest rate futures contract: underlying assetis 3-month Ringgit Inter-bank money marketdeposit.

With KLIBOR futures the corporations andfinancial institutions would be able to mange theirringgit expoures more effectively.


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Example of instrumentThree month KLIBOR futures:

Contract size : a ringgit inter-bank time deposit of RM1 mil with a 3month maturity on a 360 day year.

Delivery months : March, June, September and December up to 3years ahead

Minimum price movements : a tick or 0.01% equivalent to RM25per contract

Pricing/price quotation : similar to other short-term interest rate

futures contracts, being priced on an index basis.


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Margin requirements for an investor for futurescontract traded:

Investors have to deposit an initial sum of money with the brokersfor each futures contract traded (initial margin).

The margin being set by clearing house; may vary from time totime.

Brokers might require client pay higher amount of deposit according

to their risk assessment of the client.

Clearing house requires variation margin to be settled daily based onthe daily value of the futures trades; position that a traders holdbeing revalued according to the most current prices.


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Participants

Regulator : SC

Clearing house : Bursa Malaysia DerivativesClearing Berhad

Exchange : Bursa Malaysia Derivatives Berhad

Intermediaries : Brokers, fund managers, tradingadvisors.

Users/clients : Hedger, speculator, arbitrageurs


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Derivatives markets in Malaysia KLCE opened in 1980 : crude palm oil futures.

KLFM (1992) renamed as MME (1995)

MME (1996) : Futures and Options exchange3-month KLIBOR futures was launched

KLOFFE opened in 1995

KLCE renamed as COMMEX (1998)

COMMEX and MME merged on December 1998 KLOFFE and COMMEX merged on June 2001 = MDEX

MDEX renamed as Bursa Malaysia Derivatives Berhad


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Relevance of futures and optionsto the capital market:

Futures/options provide hedging and assetallocation facilities.

Allow investors to hold larger debt and equity

positions.

An active derivatives market that complements the

capital market will enable investors to hedge or

adjust their positions.

Documents

Chapter 5, DERIVATIVES MARKET