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 one’s exposure to today’s
volatile market.

 Objectives : speculation, reduce portfolio risk.

 Instruments : forward, futures, options

 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 for forward delivery.

 The contract specifies : what is being exchange,

the price at which the exchange takes place, the date in the
future at which the exchange takes place
 Forward contract is a tailor-made contract.

 Cannot be cancelled without the agreement of both

parties.

 Not liquid/marketable.

 No guarantee that one party will not default.

 Traded OTC
 Futures contracts
 “ an agreement between 2 counterparties to buy or sell the
underlying instrument at a specific time in the future for a
specific price determined today.”

 Different from forward.

 Standardized agreement to exchange specific types of good, in

specific amounts & at specific future delivery/maturity dates.

 Traded on the exchange

 Types of market participants

 Hedgers – protecting the value of their portfolio

 Speculators – profit

 Arbitrageurs – profit
Example:
 A futures contract for the purchase of 1,000 ounces of silver at $7
per ounce.

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

 The seller of the contract, the short position, receives the $7,000 and
delivers 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 the
buyer pays only $7,000.

 If the price falls to $6 per ounce, the buyer needs to pay $1,000 to
the seller to make sure the seller receives $7,000.
 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 Deliver the commodity / asset
the settlement date on the settlement date

What happens to this person’s Credited Debited

margin account after a rise in
the market price of the
commodity or asset?

Who takes this position to The user of the commodity or The producer of the
hedge? buyer of the asset who needs commodity or owner of the
to insure against the price asset who needs to insure
rising against the price falling

Who takes this position to Someone who believes that Someone who believes that
speculate? the market price of the the market price of the
commodity or asset will rise commodity or asset will fall
 OPTIONS
 Like 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.
 Options contracts

 “an option gives to its holder the right but not the
obligation to buy or sell a certain quantity
underlying security at a fixed price (exercise price/
strike price) at or before a specific date (the
maturity date/ expiry date by paying a premium”.
A call option – a right to buy a given quantity of
an underlying 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 holder the right to buy 100 shares of
I0I for RM9 apiece prior to the third Friday of
March 2010.
 - The holder has the option to buy and will do so only
if buying is beneficial.

- Whenever the price of the stock is above the

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

- The writer of the call option must sell the

shares if and when the holder chooses to use the call
option.
 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.
Two types of call and put:

1. American options
can be exercised on any date from the time they
are written until the day they expire.

2. European options
can be exercised only on the day that they are
expire.
 Calls Puts

Buyer Right to buy the Right to sell the

underlying asset at the underlying asset at the
strike price prior to or on fixed price prior to or on
the expiration date the expiration date

Seller Obligation to sell the Obligation to buy the

underlying asset at the underlying asset at the
strike price strike price
Option is in the money Price of underlying asset is Price of underlying asset is
when…. above the strike price below the strike price

Who buys one Someone who: Someone who:

-Wants to buy an asset in - Wants to sell an asset in
the future and insure the the future an insure the
price paid will not rise price paid will not fall
 Calls Puts

Who buys one - Wants to bet that the - Wants to bet the the price
price of the underlying of the underlying asset will
asset will rise fall

Who sells one to speculate Someone who Someone who

-Wants to bet that the - Wants to bet that the
market price of the market price of the
underlying asset will not underlying asset will not
rise fall
 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
 Example of instrument
Three Month KLIBOR Futures:
 An interest rate futures contract: underlying asset
is 3-month Ringgit Inter-bank money market
deposit.

 With KLIBOR futures the corporations and

financial institutions would be able to mange their
ringgit expoures more effectively.
 Example of instrument
Three month KLIBOR futures:

 Contract size : a ringgit inter-bank time deposit of RM1 mil with a 3

month maturity on a 360 day year.

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

years ahead

 Minimum price movements : a tick or 0.01% equivalent to RM25 per

contract

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

futures contracts, being priced on an index basis.
 Margin requirements for an investor for futures
contract traded:
 Investors have to deposit an initial sum of money with the brokers
for each futures contract traded (initial margin).

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

 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

on the daily value of the futures trades; position that a traders hold
being revalued according to the most current prices.
 Participants
 Regulator : SC
 Clearing house : Bursa Malaysia Derivatives
Clearing Berhad
 Exchange : Bursa Malaysia Derivatives Berhad
 Intermediaries : Brokers, fund managers, trading
advisors.
 Users/clients : Hedger, speculator, arbitrageurs
 Derivatives markets in Malaysia
 KLCE opened in 1980 : crude palm oil futures.
 KLFM (1992) renamed as MME (1995)
MME (1996) : Futures and Options exchange
3-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
 Relevance of futures and options
to the capital market:

 Futures/options provide hedging and asset

allocation 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.