Futures, Hedging & Commodity Trading at NCEL

ICAP

KarachiThursday, May 13, 2004

Agenda• Derivatives• Forwards & Futures• Hedging Strategies• Futures Exchange – An antidote

to WTO• NCEL• Q&A

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables

Examples of Derivatives• Forward Contracts

• Futures Contracts

• Swaps

• Options

Derivatives Markets• Exchange traded

– Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading

– Contracts are standard – There is virtually no credit risk as exchanges are

CCP’s

• Over-the-counter (OTC)– A computer- and telephone-linked network of

dealers at financial institutions, corporations, and fund managers

– Contracts can be non-standard and – There is credit risk (counterparty risk)

Ways Derivatives are Used

• To hedge risks• To speculate (take a view on the

future direction of the market)• To lock in an arbitrage profit• To change the nature of a liability• To change the nature of an investment

without incurring the costs of selling one portfolio and buying another

Forward Contracts

• A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price)

• It can be contrasted with a spot contract which is an agreement to buy or sell immediately

• It is traded in the OTC market

Forward Price• The forward price for a contract is the

delivery price that would be applicable to the contract if were negotiated today

• The forward price may be different for contracts of different maturities

Foreign Exchange Quotes for GBP/US$ on Aug 16, 2003

Bid Offer

Spot 1.4452 1.4456

1-month forward 1.4435 1.4440

3-month forward 1.4402 1.4407

6-month forward 1.4353 1.4359

12-month forward 1.4262 1.4268

Example • On August 16, 2001 the treasurer of a

corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.4359

• This obligates the corporation to pay $1,435,900 for £1 million on February 16, 2002

Futures Contracts• Agreement to buy or sell an asset for a

certain price at a certain time

• Similar to forward contract

• Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

• Virtually no credit risk as the exchange is a CCP

Other Key Points About Futures

• Standardized contract• Quality is pre-defined and permissible variation

is settled through premium or discount• Requires a margin prior to taking a position• They are settled daily – marked to market• Variation margin is payable in cash only• Closing out a futures position involves entering

into an offsetting trade• Most contracts are closed out before maturity –

98%

Forward Contracts vs Futures Contracts

Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at maturity Settled daily

Delivery or final cashsettlement usually occurs

Contract usually closed outprior to maturity

FORWARDS FUTURES

Examples of Futures Contracts

• Agreement to:

– buy 100 oz. of gold @ US$300/oz. in December (COMEX)

– sell £62,500 @ 1.5000 US$/£ in March (CME)

– sell 1,000 bbl. of oil @ US$20/bbl. in April (NYMEX)

What Determines Basis ?

As basis reflects local market conditions it is directly influenced by several factors such as :

• Interest / Storage Costs

• Transportation costs

• Local supply and demand conditions

• Handling Costs

Basis Terminology

Gold spot Rs 7,200

November Futures Rs 7,220

Basis - Rs 20 Nov

The basis is “20 under November”

Basis Terminology

Gold spot Rs 7,200

November Futures Rs 7,180

Basis Rs 20 Nov

The basis is “20 over November”

Strengthening Basis

If the spot price increases relative to the futures price, or the difference between the spot price and futures price becomes less negative (or more positive).

A strengthening basis works to a sellers advantage.

Weakening Basis

If the spot price decreases relative to the futures price, or the difference between the spot price and futures price becomes more negative (or less positive).

A weakening basis works to a buyers advantage.

Convergence of Futures to Spot

Time Time

(a) (b)

FP

SP

Basis = Sp – Fp

B < 0 B > 0

SP

FP

Gold: An Arbitrage Opportunity?

• Suppose that:- The spot price of gold is US$300- The 1-year forward price of gold is

US$340- The 1-year US$ interest rate is 5%

per annum• Is there an arbitrage opportunity?

(We ignore storage costs)?

The Forward Price of Gold If the spot price of gold is S and the forward

price for a contract deliverable in T years is F, then

F = S (1+r )T

where r is the 1-year (domestic currency) risk-free rate of interest.In our examples, S = 300, T = 1, and r =0.05 so that

F = 300(1+0.05) = 315

Oil: An Arbitrage Opportunity?

Suppose that:- The spot price of oil is US$19- The quoted 1-year futures price of

oil is US$25- The 1-year US$ interest rate is

5% per annum- The storage costs of oil are 2%

per annum• Is there an arbitrage opportunity?

Delivery

• If a contract is not closed out before maturity, it usually settled by delivering the assets underlying the contract.

• When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses.

• A few contracts (for example, those on stock indices and Eurodollars) are settled in cash

Delivery Instruments

• Vault Receipts are used for the delivery of precious metals and certain financial instruments. E.g. Gold

• Warehouse Receipts are used with delivery of grain. E.g. Wheat

• Demand Certificates are used with delivery of perishables.

Margins• A margin is cash or marketable securities

deposited by an investor with his or her broker

• The balance in the margin account is adjusted to reflect daily settlement

• Margins minimize the possibility of a loss through a default on a contract

How Margins Work ?• An initial margin must be deposited at the

time the contract is entered

• Margin account is “marked to market” on a daily basis i.e. adjusted to reflect the investors gain or loss – direct debit

• The investor is entitled to withdraw any balance in the margin account in excess of the initial margin – in case of NCEL we will pay only if requested

How Margins Work ?• To ensure a certain minimum balance in margin

account a maintenance margin is set.• If margin account balance falls below the

maintenance margin, the investor receives a margin call and is expected to top up the account to the initial margin level the next day

• Spot month margins will be required in the delivery month

• Delivery margin, which could be as high as 25%

How Margins are Determined ?• Initial margin is based on a scientific risk

management methodology called Value at Risk (VaR)

• VaR is a method of assessing risk that uses standard statistical techniques routinely used in other technical fields.

• Methodologies such as variance/covariance, EWMA, historical simulation, etc.

• Formally, VaR measures the worst expected loss over a given time interval under normal market conditions at a given confidence level

• Exchanges use SPAN, TIMS, PRISM, etc.

Value-at-Risk

Gold Prices

Gold price, US$ per ounce, London pm fix

200

250

300

350

400

450

J an-00 May-00 Sep-00 J an-01 May-01 Sep-01 J an-02 May-02 Sep-02 J an-03 May-03 Sep-03 J an-04

Sigma = 2 VaR @ 99%

0.0000%

1.0000%

2.0000%

3.0000%

4.0000%

5.0000%

6.0000%

7.0000%

Series1

Series2

Sigma = 4 VaR @ 99%

0.0000%

1.0000%

2.0000%

3.0000%

4.0000%

5.0000%

6.0000%

7.0000%

8.0000%

9.0000%

10.0000%

Series1

Series2

Example of a Futures Trade• An investor takes a long position in 2

December gold futures contracts on June 5– contract size is 100 oz.– futures price is US$400– margin requirement is US$2,000/contract (US$4,000

in total)– maintenance margin is US$1,500/contract

(US$3,000 in total)

A Possible Outcome

Daily Cumulative Margin

Futures Gain Gain Account Margin

Price (Loss) (Loss) Balance Call

Day (US$) (US$) (US$) (US$) (US$)

400.00 4,000

5-Jun 397.00 (600) (600) 3,400 0. . . . . .. . . . . .. . . . . .

13-Jun 393.30 (420) (1,340) 2,660 1,340 . . . . . .. . . . .. . . . . .

19-Jun 387.00 (1,140) (2,600) 2,740 1,260 . . . . . .. . . . . .. . . . . .

26-Jun 392.30 260 (1,540) 5,060 0

+

= 4,000

3,000

+

= 4,000

<

Futures Market

Futures Exchange• Contracts are standardized

• Trading is centralized

• Market-making is competitive

• Third-party guarantee of contract performance

• Do not have to borrow or own underlying to short sell

• Trading is certificateless

• Low transaction costs

• Aid in price discovery and serve as a reference point– Participants attracted to markets– Additional resources spent on information

collection and analysis– Arbitrage between markets transmits the

new information throughout the complex of markets

How Do Derivative Contracts Improve Market Operations?

"Forward Looking" Prices• Futures prices are estimates of future cash

prices

• Price basing refers to the practice of using futures prices as a base or reference point for other transactions

Do Futures Stabilize Cash Prices?

• Investment is encouraged because of low transaction costs

• Investors are likely to drive prices to levels justified by economic fundamentals

• Volatility in futures and options prices transmitted to cash by arbitrage

• Removes distortions and fragmentation

How Do Derivative Contracts Improve Market Operations?

• Facilitate the exchange of risk across market participants

– A commercial risk is transferred to someone more willing to bear the risk

– Exchange-traded futures facilitate trade between strangers

– May improve the liquidity of underlying cash markets

Wheat Price Comparison between Major & Minor Pakistani Markets

(For Three Years)

400

500

600

700

800

900

1000

Ru

pees/1

00 K

g

Source: Federal Bureau of Statistics

Red = Average of Three Major Markets

Yellow = Average of 9 minor Markets

Sowing

Sowing Harvesting

Harvesting

Harvesting

Sowing

2000-01 2001-02 2002-03

Hedging

Types of Traders

• Hedgers

• Investors

• Arbitrageurs

Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

Long & Short Hedges• A long futures hedge is appropriate when

you know you will purchase an asset in the future and want to lock in the price

• A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

Arguments in Favor of Hedging

• Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

Choice of Contract• Choose a delivery month that is as close

as possible to, but later than, the end of the life of the hedge

• When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price.

Hedging

Strategy to reduce risk of future price volatility

• e.g., suppose you (a garment manufacturer) signed a contract to sell jeans over 1 year at a fixed price – options:

• buy all denim cloth requirements now– need storage space; have to incur carrying cost

• buy yarn futures contracts with delivery dates spread out through out the year

Hedging Examples • A garment exporter will receive $1

million for exports to the US in 3 months and decides to hedge using a short position in a forward contract

• A yarn manufacturer imports machinery for $1 million for which payment will be made in 6 months will use long position in a forward contract

Yarn – Price Correlation

-

100

200

300

400

500

600

700

800

Source:Aptma Website

Mon

thly

Avg

Yar

n Pr

ices

10/1 16/1 21/1 26/1 30/1

NCEL: An antidote to WTO

Textiles - End of Quotas!• Sudden drop in protection after 50 years• Production and market share is unfrozen• Quota holding is no longer passport to Western

Markets• Market share will be gained through international

competitiveness• More players leads to falling prices• “There is always someone cheaper”• Hedging platform is a necessity for the value

added textile sector

Price Trend

Cotton Prices

Cotton Prices

Exchange Rates

Percentage Change of Average Monthly Yarn prices of 21/1

-30%

-20%

-10%

0%

10%

20%

30%

40%

Source: Aptma Website

%ag

e C

hang

e

1M 3M 6M

2000-01 2001-02 2002-03 2003-04

NCEL: An Antidote to WTO• Platform for hedging – lock in prices• Will allow manufacturers to manage raw

materials price-risk – in case of textile related industries it is as high as 80%

• Exporters can enter into longer term contracts

• Less chances of reneging on contracts• Overall, has a smoothening effect on prices• Positive impact on employment and poverty

alleviation

NCEL

Background• NCEL established on April 20, 2002• Permission granted by SECP on May 16, 2002• Present Shareholders

– KSE-40%– LSE-10%– ISE-10%– Pak Kuwait Investment Co. – 10% – Zarai Taraqiati Bank Ltd. – 10%

• Paid-up-Capital Rs.40 million (post ZTB)• Additional FI participation (20%) being

considered • Authorized Capital Rs.50 million

Highlights• First de-mutualized exchange in Pakistan

• First fully integrated electronic exchange capable of also handling financial futures

• First to employ modern risk management techniques – Value-at-Risk

• First to introduce the concept of “The Central Counterparty”

• First to introduce Vault Receipts and Warehouse Receipts – negotiable instruments

• First to develop a “Spot Yield Curve” for the market

Key Drivers for Success• Provide a transparent platform for easy and

equal access for all participants

• Trading Regulations will provide complete confidence and protection to investors and users

• Risk Management, and Surveillance & Monitoring will be based on the international “Best Practices”

• Developing thoroughly researched contract specifications

Target Market

• GDP - Rs4,042 billion (2002-03)

• Agriculture contributes 24 % - Rs970 billion

• Share of major crops 9.6% - Rs388 billion

• Textiles represent 10.5% - Rs424 billion

• Crude oil & oil products imports - Rs156 billion

• Palm oil imports - Rs26 billion“Internationally the multiple for cash

versus futures is 5-70 times”

Vision/MissionFROM• Price distortions• Wide spreads or one way

quotes• Absence of

standardization• Counterparty risk• Impediments in financing• Price manipulation

TO• Observable future prices • Narrow spreads and two way

quotes• Quality certification &

standardization• Risk mitigation• Ease in financing• Price dissemination

“To provide an opportunity to the farmers to farm for the market”

Warehouses Clearing Banks

Accepted Orders

Cancelled/Expired Orders Cancelled/Expired Orders

NCEL Business Process

On a daily basis

Each matched order has a buyer and a seller

Central Order Book

Order Matching

Matched Order (Trade)

Clearing & Settlement

Settlement Price Computation

Mark-to-Market

Settlement PaymentsReceipt Margins

Variation Margins FeeDelivery Margins

Delivery Order Rate

Contract Maturity Processing

Delivery OrdersDelivery Allocation

NCEL Buyer

Order Routing

NCEL Seller

Rejected Orders

Orders

Rejected Orders

Orders

Upon expiryof contract

Pre-Trade Risk Checks

Post Trade Risk Checks

Quality & Quantity Certification

Online Bank Transfers

Central Order Book

Order Matching

Matched Order (Trade)

Clearing & Settlement

Settlement Price Computation

Mark-to-Market

Settlement PaymentsReceipt Margins

Variation Margins FeeDelivery Margins

Delivery Order Rate

Contract Maturity Processing

Delivery OrdersDelivery Allocation

NCEL Buyer

Order Routing

NCEL Seller

Rejected Orders

Orders

Rejected Orders

Orders

Upon expiryof contract

Pre-Trade Risk Checks

Post Trade Risk Checks

Quality & Quantity Certification

Online Bank Transfers

Contract Development

Syn. Fibre

Weaving

Knitting

Processing Spinning

Apparel &Garments

Ginning

Seed Cotton

Lint Cotton

Yarn

Textiles Process

Price Trend of Pakistani Wheat (For Three Cropping Seasons)

650

700

750

800

850

900

Oct Nov Dec Jan Feb Mar Apr May

Ru

pees/1

00 K

g

2000-01 2001-02 2002-03

Sowing Period

Harvesting Period

Source: Federal Bureau of Statistics*Prices are the Average of 12 Pakistani Markets

Agriculture Sector• Tenant farmers do not have access to

organized financial sector

• Borrows from unorganized sector at rates as high as 120% per annum

• Forced to sell immediately upon harvest – no holding power

• Compromise on inputs – low yield per acre

• Lack of infrastructure – warehousing

• Middleman provides a one stop shop!

Commodity Based Financing• Structured form of financing with an

objective of transferring risk from an entity to a commodity

• In discussion with a NGO to undertake financing as a pilot project on the following basis :1. Pre-sowing for inputs against NCEL

contract (short) and social collateral

2. Post-harvest and upon storage against a warehouse receipt

Farmers

NGO NCEL

Entire profits go to the farmer if NGO manages price risk using NCEL

Middleman effectively eliminated from process

Financing Mechanism

Middleman

NGO views futures prices at

NCEL and enters into a contract

Cash

Seeds

Other

inputs

Crop

Cash

Warehouse Receipt

360° Company Update• Hardware and software has been installed

• Software is being configured

• Gold and Cotton Yarn contract specifications are being developed

• Regulations are being refined and have to be approved by the Board and SECP

• 95% hiring is complete

• Online bank transfer arrangements are being finalized with MCB

360° Company Update Cont’d….

• Vault arrangements are being finalized with KASB Bank Ltd.

• Mock trading will begin by 24/5/04

• “ZCYC”, “Cotton Farmers & Ginners ROI”, “Wheat Farmers ROI”, etc. White Papers are being prepared and will be presented, shortly

• Rice and Wheat contracts are being developed for next season

360° Company Update Cont’d….

• Staff is highly educated and experienced in trading futures, risk management, IT, investment banking, agriculture, textiles, financial mathematics, corporate & securities law, stock-broking, accounting, tax, etc……

• “Go Live” when Members are ready

Order & Trade Confirmation Process

Classification of Risk• Credit Risk

• Liquidity Risk

• Settlement Risk

• Market Risk

• Operational Risk

• Legal Risk

Risk Mitigation Strategies• Clearing Limits – Members

• Position limits – Members & Clients

• Initial & Maintenance Margins

• Variation Margin – daily MTM

• Additional Margin in the spot month to ensure convergence

• Standard NCEL approved documentation

Risk Mitigation Strategies Cont’d…

• Security Deposit

• Clearing Limit – Members

• Initial Margin – Members & Clients

• Pre-Trade Check

• Segregation• Bank Accounts – Members & Clients• Sub-accounts at CDC

• Mark-to-market daily settlement - online

• Position Limits – to counter manipulation

Margining• Example - Gold

– Clearing Deposit: Rs1.5 million = 4%– Initial Margin: Rs0.5 million = 4%

• Initial Margin: 99% VaR over 1 day

• Spot Month Margin: 99% VaR over 10 days

• Delivery Margin: 99% VaR over 3 days

Market Surveillance• Apart from legal requirements, NCEL will

demonstrate self-regulatory presence as it is just good business practice ….

• We must win confidence of participants and demonstrate that there is integrity in our market

• Must protect investors in our marketplace

Market Surveillance Cont’d…

To identify situations that could pose a threat to manipulation and to initiate preventive action by monitoring:

a. Large tradersb. Key price relationshipsc. Supply and demand factorsd. Spot market activities

Zero Coupon Yield Curve (ZCYC) • Also known as the Spot Yield Curve• NCEL will use ZCYC for calculating theoretical

futures price• ZCYC can be used to price wide range of

securities including coupon paying bonds, derivatives, FRAs and swaps

• NCEL is estimating ZCYC using primary market data for Government securities

• Can also be used to price non-sovereign fixed income instruments after adding in credit spreads

Thank You