Task 1

Determine the fair price of a future contract that you have chosen and explain that
affect its pricing.

FCPO spot = RM 2,689 (Appendix 1)

FCPO future= RM 2,671 (Appendix 1)

Future maturity= 90days

Current Inventory= 250 (Assumptions)

Rf rate =2.92% (Appendix 2)

𝐹𝑡,𝑇 = 𝑆0 (1 + 𝑟𝑓 + 𝐶 − 𝑦)𝑡,𝑇

𝐹𝑡,𝑇 = Futures price for a contract with maturity from t to T (t=today, T=maturity)

𝑆0 = Current spot price of the underlying asset

𝑟𝑓 = Annualized risk free rate

𝐶 = Annual storage cost in percent

y = Convenience yield

Calculate fair price

Ft ,T= S0 ( 1+rt+c-y)

=2,689(1+0.0292+30/2,689)0.25=2,715.72 (Undervalued)
Factors affect the price of CPO

Supply and demand of palm oil

The price of the crude palm oil will increased due to the increase the demand in the palm oil
and vice versa. Country such as China, India and Europe are the main importers of the palm
oil and this is the biggest factor that affect the price of crude palm oil. For example crisis that
arise like the downturn in the global economic, the euro zero debt crisis and also the crisis of
slowing food demanding in the country like China and India will cause the lesser demand of
crude palm oil. These crisis will directly affect the spending on the imports. Hence, the
decrease in the demand of palm oil will decrease the price of palm oil, this will affect the
profit of a counties which are the palm oil supplier for example like Malaysia and Indonesia.
(Anon., 2017)

Price of competing vegetable oil

The price of palm oil will affected by vegetable oils like sunflower oil, soybean oil and corn
oil because the vegetable oils are the competitor of the palm oil. The price between
competitors always have the negative relationship for example when the supply of sunflower
oil decrease the demand will decrease, this will help to increase the price of palm oil. (Anon.,
2017)

Changes in the weather pattern

For example like Malaysia and Indonesia are the tropical countries this is the reason why
suitable for plantations of palm oil. Natural disaster will affect the price of palm oil. For
example, heaving rain will cause flood the plantations and affect the harvesting. (Anon.,
2017)

Changes in taxation and import duty

Dorab Mistry who is an international palm oil industry analyst had stated that to protect its
own farmers India should impose at least 10% of tax on the import crude palm oil. If this
implemented will force the palm oil supplier countries like Malaysia to increase the price of
export of palm oils. (Anon., 2017)
Task 2

Hedging

Hedging refers a risk management strategy used in the futures market as a place to transfer
price risk. They trade in the futures market and the spot market at the same time in the
opposite amount and in the opposite direction. This is not only carried out in the futures
market, but also in the spot market. This type of hedging transaction is mainly intended to
sidestep the risks posed by price changes in the spot market and to give up the potential gains
from price changes. Hedging is used through investing in high-yield financial instruments
(bonds, notes, shares), real estate, or precious metals in order to protect one's capital against
effects of inflation. Those used type of hedging strategies are called as hedgers.

FCPO spot price RM2,689 (Appendix 1)

3-month CPO futures RM2,671 (Appendix 1)
Risk-free rate 2.92% ( Appendix 2)
Annual storage cost RM30
Tons per contract 25 tons
Quantity of CPO being hedged 500 tons
No. of contracts = = = 20 contracts
Contract Size 25 tons per contract

3-month storage cost

= CPO contract value × annual storage cost × holding period

= (2,689 × 25 × 20) × (30/2,689) × (90/360)

= RM3,750

At first, the refiner is in hedging position as he intends to protect the CPO future
contract from the price fluctuation risk. Hedging position is an investment that when you are
making an offsetting investment that can reduce the risk. Hedging position can be determined
by two correspondent ways which are by determining it in long position way or short position
way. Based on the above situation, the refiner has to short future in the FCPO contract so that
he will be able to hedge the risk.
 Scenario 1 (CPO Future price decrease)
Action Position today (RM) Maturity (RM) Storage cost Profit/Loss
(RM) (RM)
Long inventory 2,689 × 25 × 20 *2,640 × 25 × 20 (24,500)
-
position = 1,344,500 = 1,320,000
Short 20 FCPO 2,671 × 25 × 20 *2,640 × 25 × 20 11,750
3,750
= 1,335,500 = 1,320,000
Net loss = (12,750)
*The future price of RM2,640 is just an assumption.
In scenario 1, we can see that the refiner is facing the risk of loss when the CPO future price
decrease. If he didn’t carry out any position in hedging the price fluctuation’s risk, most
probably he will be making more loss.
Scenario 2 (CPO future price increase)
Long inventory 2,689 × 26 × 20 2,738 × 25 × 20
- 24,500
position = (1,344,500) = 1,369,000
Short 20 future 2,671 × 25 × 20 2,738 × 25 × 20
3,750 (37,250)
contracts = 1,335,500 = (1,369,000)
Net Loss = (12,750)
In scenario 2, the refiner expect that the CPO future price to increase. Hence, the refiner
carries out long inventory position in order to hedge the risk when the CPO future price
increase. Even though he gains a net loss at last, however through long inventory position
that carried out by him. I believe if without long inventory position, he is going to suffer
more loss.

In conclusion, the FCPO contract can be used by the refiner in order to hedge their risk
by using the two methods which are short position or long position. According to the two
scenarios that we have done, we can see that the refiner will be facing the risk of losing more
profit if he did not carry out any position to hedge the risk when the price in future is decreasing
or increasing. Although at last he is getting a net loss, but through long inventory position in
FCPO contract, he is able to reduce the loss that he makes.
Task 3

The example of reverse cash and carry arbitrage as below:

Arbitrage

Arbitrage refers to the use of the spread between the interest rate of the two places and the
difference in exchange rates of currency and the current capital of investors or borrowers to
make profit. Usually refers to a condition that the kind of physical assets or financial assets
(in the same market or in different markets) have two prices, ones buy at a lower price, and
another used higher prices to sell, in order to gain the low-risk returns. For example, a stock
that is listed on the London and New York exchanges at the same time with the same shares.
However, a price of 10 dollars in New York and 12 dollars in London means that investors
can buy in New York and sell in London.

Assumption: Long 1 CPO future contract

a.) If CPO rises by 10% at maturity

(2,689 x 110% = 2,957.9)

Position Position Maturity(RM) Profit/loss(RM)

Today(RM)

Long 1 CPO future 2,671x25= 2,957.9x25= 73,947.5 7,172.5

(66,775)

Short spot contract 2,689x25= 67,225 2,957.9x25= (73,947.5) (6,722.5)

Carrying cost 67,225 67225(1+0.0292+30/2689)^0.25 668.21

Net profit 1,118.21
 b.) If CPO falls by 10% at maturity

(2,689 x 90% = 2420.1)

Position Position Maturity(RM) Profit/loss(RM)

Today(RM)

Long 1 CPO future 2,671x25= 2,420.1x25= 60502.5 (6,272.5)

(66,775)

Short spot contract 2,689x25= 2,420.1x25= (60502.5) 6,722.5

67,225

Carrying cost 67,225 67225(1+0.0292+30/2689)^0.25 668.21

Net profit 1,118.21

So, we calculated the price of RM2715.72 on the above is more than RM2671 which is the 3
months future price. We should use reverse cash and carry arbitrage strategy in order to earn
the money. Based on the first table above, it shows that the net profit can be earn when the
CPO price rises by 10 percent at maturity namely RM2957.9. Next, we must long 1 CPO
future contract in order to earn RM7297.5 and also lend out the money with 2.92% of interest
by shorting the spot market of 90 days. Moving on, the amount of RM187.5 is paid for the
storage cost. Lastly, this arbitrage has earned a net profit of RM1118.21.

For the second table, it shows that when the CPO falls by 10 percent at maturity which is
RM2420.1 but the net profit also can be earned which is also the same situation as the first
table as well. Both of the table shows that using the way of cash and carry arbitrage can gain
profit of RM1118.21.
Task 4

Speculation and hedging are just the opposite. Speculation is not that to avoid foreign
exchange risks, but to accept or using that risks. Speculation is not only to minimize losses,
but also to maximize the profit. The changing exchange rate provides the opportunity and the
conditions for speculators to pursue profits. Speculators focus on price changes, sometimes
using asymmetric information to look for the opportunity in profit. It is a behaviour of
speculators that takes a higher risk in order to get a huge profit. Speculators could be long or
short. Speculators are willing to bear the risk of the change of futures price. Once the price is
expected to rise in futures, the speculators will buy the futures contracts. However, if the
futures prices are forecast to fall, the speculators will sell the futures contracts and take the
opportunity to hedge them when the price changes into the same direction as they expected.
Usually speculators take a big risk in the futures market.

A trader who speculate in FCPO market and he or she expects that the price of CPO future
price will rise in the next three months. Since the trader expects that the CPO prices will
headed higher in next three months, so the trader would long his or her CPO futures
contracts.

Scenario 1: Price rising (bullish market)

To speculate, the trader should long 20 CPO futures contract at quoted price of 2689 per ton
which is on 2 Oct 2017. (Refer to appendix)

3 months later, the CPO future price rises to 2823 which is increased about 5% of spot price.
Position payoff: Profit = (2823 – 2689) × 25 × 20

= 67,000

At the end of the period, the trader will gain a profit of RM 67,000.

*The CPO futures contracts have a contract size of 25 tonnes.

Scenario 2: Price falling (bearish market)

To speculate, the trader should long 20 CPO futures contract at quoted price of 2689 per ton.

3 months later, the CPO future price falls to 2501 which is decreased about 7% of spot price.

Position payoff: Profit = (2501-2689) × 25 × 20

= -94,000

At the end of the period, the trader will loss RM 94,000.

*The CPO futures contracts have a contract size of 25 tonnes.

Appendix 1

Appendix 2

Appendix 3
Reference

1. Anon, 2017. 5 Factors that Affect Crude Palm Oil (CPO) Prices, viewed 30 November
2017, <http://www.opf.com.my/blog/5-factors-that-affect-crude-palm-oil-cpo-prices/>.