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CHAPTER 2

CONCEPTS OF
DERIVATIVES
DERIVATIVES

1. FORWARD
2. FUTURES
3. OPTIONS
4. SWAPS
INTRODUCTION
◦ The price of a derivatives instrument is derived from the actual price of the
underlying asset/physical at the cash market (local delivered).
◦ Derivatives requires involves :
◦ two instruments; derivatives (financial) and physical/cash instruments two
markets; derivatives (future) and physical (spot/cash/local delivered) markets.

◦ CPO Cash MARKET FUTURE CPO (derivatives)

◦ CPO CASH MARKET 15.10.2020 = RM 3019


◦ FUTURES CPO NOV 2020= RM 2985

◦ CPO CASH MARKET 15.10.2020 = RM 3019 – converged price


◦ FUTURES CPO NOV 2020= RM 3019 – converged price
INTRODUCTION (CONT’D)

◦ Derivatives is a contract to buy (LONG POSITION) and sell


(SHORT POSITION) which is set today, but will be fulfilled at a
stipulated date, later.
◦ The performance (price) of the derivative market depends on
the performance (price) of the physical/cash market.
Convergence of Futures to
Spot/Cash

Futures Price (premium)

Spot Price

Futures Price (discount)

t1 t2 Time
MPOB – Cash market
Bursa Malaysia- Future market
TYPES OF DERIVATIVES MARKETS

FORWARD
§ It is a private contract/agreement to buy and sell a specified security at a
specified price to be delivered at the maturity date in the future using over-the-
counter (OTC) market.

FUTURES
§ Futures market develops as a result of insufficient trading requirement of
forward transactions.
§ It is a contract/agreement to buy and sell a specified security at a specified price
to be delivered at the maturity date in the future using the exchanged-traded
market.

OPTIONS
§ Options trading are a contract/agreement that gives a right without obligation
to the buyer, while the seller has an obligation if requested by the buyer, to buy
or sell at specified prices and time using the exchanged-traded market.

SWAPS
• A swap is a private contract/agreement to swaps or exchanges a specified
security for specified cash flow using over-the-counter (OTC) market. For
example, currency swaps and interest rate swaps.
Zero-Sum Game
What Is a Zero-Sum Game?
◦ Zero-sum is a situation in game theory in which one person’s gain
is equivalent to another’s loss, so the net change in wealth or
benefit is zero.
◦ A zero-sum game may have as few as two players or as many as
millions of participants.
◦ In financial markets, options and futures are examples of zero-sum
games, excluding transaction costs. For every person who gains
on a contract, there is a counter-party who loses.
◦ In the future market, trading is often thought of as a zero-sum
game. However, because trades are made on the basis of future
expectations, and traders have different preferences for risk.
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.
◦ Forward contracts can be tailored/customized to a specific
commodity, amount and delivery date.
◦ A forward contract can be used for hedging or speculation,
although its non-standardized nature makes it particularly
appropriate for hedging.
◦ Forward contracts trade on over-the-counter (OTC) market.
◦ While their OTC nature makes it easier to customize terms, the
lack of a centralized clearinghouse and 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 future contracts.
Example Forward Contract
◦ Assume that an agricultural producer (seller) has two million
bushels of corn to sell six months from now and is concerned
about a potential decline in the price of corn.
◦ Thus, the seller enters into a forward contract with its financial
institution to sell two million bushels of corn at a price of $4.30 per
bushel in six months, with settlement on a cash basis.
Example Forward Contract
◦ In six months later, the cash/spot price of corn has three
possibilities:
1. It is exactly $4.30 per bushel (break even). In this case, no monies are
owed by the producer or financial institution to each other and the
contract is closed.
2. It is higher than the contract price, say $5 per bushel. The producer
owes the institution $1.4 million, or the difference between the current
spot price and the contracted rate of $4.30.
3. It is lower than the contract price, say $3.50 per bushel. The financial
institution will pay the producer $1.6 million, or the difference
between the contracted rate of $4.30 and the current spot price.
Futures Contract
◦ A futures contract is a legal agreement to buy (long position) or
sell (short position) a particular commodity asset, or security at a
predetermined price at a specified time in the future.
◦ Futures contracts are standardized for quality and quantity to
facilitate trading on a futures exchange (i.e Bursa Malaysia
Derivative exchange). (exchanged-traded)
◦ The futures markets are regulated by regulators (i.e Securities
Commission/ Bursa Malaysia Clearing House)
◦ The buyer of a futures contract is taking on the obligation to buy
and receive the underlying asset when the futures contract
expires, while the seller of the futures contract is taking on the
obligation to provide and deliver the underlying asset at the
expiration date.
Futures Contract (cont’d)
◦ A futures contract allows an investor to speculate on the direction of a
security, commodity, or a financial instrument, either long or short
position.
◦ Futures are also often used to hedge the price movement of the
underlying asset to help prevent losses from unfavourable price change
(price risk).
◦ Futures are available on many different types of assets. There are futures
contracts on stock exchange indexes, commodities, and currencies,
bonds, interest rates, stocks and others.
◦ Examples of Futures Contract in Bursa Malaysia Derivatives Exchange
1) FCPO (Commodity CPO futures)
2) FKLI (KLCI index future)
3) FKB3 (interest rate futures)
4) FMG5 (bond futures)
5) SSF (Single stock futures)
6) OKLI (Index Option)
7) FGOLD (Commodity gold futures)
8) FM70 (index futures)
Example Futures Contract
◦ Futures contracts are used by two categories of market
participants: hedgers and speculators.
◦ Producers (seller) or purchasers (buyer) of an underlying asset hedge
or guarantee the price at which the commodity is sold or purchased,
while portfolio managers and traders may also make a
bet/speculation on the price movements of an underlying asset using
futures.
◦ An oil producer needs to sell their oil. They may use futures contracts
do it. This way they can lock in a price they will sell at, and then
deliver the oil to the buyer when the futures contract expires.
◦ Similarly, a manufacturing company may need oil for making
widgets. Since they like to plan ahead to buy and always have oil
coming in each month, they too may use futures contracts. This way
they know in advance the price they will pay for oil (the futures
contract price) and they know they will be taking delivery of the oil
once the contract expires.
Example Futures Contract (cont’d)
◦ Imagine an oil producer (i.e Petronas) plans to produce
one million barrels of oil over the next year. It will be ready for
delivery in 12 months. Assume the current price is $75 per barrel.
The producer could produce the oil, and then sell it at the current
market prices one year from today.
◦ Given the volatility of oil prices, the market price at that time
could be very different than the current price. If oil producer
thinks oil will be higher in one year, they may opt not to lock in a
price now.
◦ But, if they think $75 is a good price, they could lock-in a
guaranteed sale price by entering into a futures contract.
Options Contract

◦ Options trading are a contract that gives a right without obligation to


the buyer, while the seller has an obligation if requested by the buyer,
to buy or sell at specified prices and at or prior maturity time.
◦ Specifically, options contract is an agreement between two parties
(buyer and seller) to facilitate a potential transaction on
the underlying security/assets (commodity/interest rate/currency) at
the strike/exercise price, at or prior the expiration date.
◦ The two types of contracts, which are put option (option to sell) and
call option (options to buy).
◦ Both of the options can be purchased in order to speculate on the
direction of stocks or indices to generate profit.
◦ i.e- There is a stock options (Maybank options) and stock index
options (KLCI options).
Options Contract (cont’d)
◦ In general, call options can be purchased as a leveraged bet on
the appreciation/increase of a stock or index, while put options
are purchased to profit from price declines/drops.
◦ The call buyer has the right to exercise but not the obligation to
buy the number of shares covered in the contract at the strike
price.
◦ Put buyers also have the right but not the obligation to sell shares
at the strike price in the contract.
◦ Option sellers, on the other hand, are obligated to the buyer in
order to transact their side of the trade if a buyer decides to
exercise/execute a call option to buy the underlying security or
execute a put option to sell.
◦ Options are generally used for hedging as well as for speculation
purposes.
Example Options Contract
◦ To buy a call option , the traders needs to pay the price in the
form of an option premium when expect price to increase.
◦ As mentioned, it is upon the discretion/right of the owner on
whether he wants to exercise this option. He can let the option
expire if he deems it unprofitable. The seller, on the other hand, is
obligated to sell the securities that the buyer desires. In a call
option, the losses are limited to the options premium, while the
profits can be unlimited.
◦ For example, an investor buys a call option for a stock of XYZ
company on a specific date at RM 100 strike price and expiry
date is a month later. If the price of the stock rises anywhere
above RM 100, say to RM 120 on the expiration day, the call
option holder can still buy the stock at RM 100.
Example Options Contract (cont’d)

◦ To buy a put option, the traders needs to pay option premium


when expect price to decrease.
◦ The PUT options give the option holder the right to sell an
underlying security at a specific strike price within the expiration
date.
◦ In case the market price is higher than the strike price, he can sell
the security at the market price and not exercise the option.
◦ Suppose an investor buys a put option of XYZ company on a
certain date with the term that he can sell the security any time
before the expiration date for RM 100. If the price of the share falls
to below RM 100, say to RM 80, he can still sell the stock at RM 100.
In case the share price rises to RM 120, the holder of the put option
will not exercise the option.
Swaps Contract
◦ A swap is a derivative contract which two parties exchange the
cash flows or liabilities from two different financial instruments.
◦ A financial swap is a derivative contract where one-party
exchanges or "swaps" the cash flows of one asset for another. The
most common kind of swap is an interest rate swap.
◦ For example, a company paying a variable rate of interest may
swap its interest payments with another company that will then
pay to the company at a fixed interest rate.
◦ Other examples, one cash flow is fixed currency rate, while other
variable is based on floating currency rate.
◦ Swaps do not trade on exchanges, and retail investors do not
generally engage in swaps.
◦ Swaps are over-the-counter contracts primarily between
businesses or financial institutions that are customized to the
needs of both parties.
Example Swaps Contract
◦ In an interest rate swap, the parties exchange cash flows based on a
notional principal amount (this amount is not actually exchanged) in
order to hedge against interest rate risk or to speculate.
◦ For example, imagine ABC Co. has just issued $1 million in five-
year bonds with a variable annual interest rate defined as the London
Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also,
assume that LIBOR is at 2.5% and ABC management is anxious about
an interest rate rise.
◦ The management team finds another company, XYZ Inc., that is
willing to pay ABC an annual rate of LIBOR plus 1.3% on a notional
principal of $1 million for five years.
◦ In other words, XYZ will fund ABC's interest payments on its latest bond
issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a
notional value of $1 million for five years.
◦ ABC benefits from the swap if rates rise significantly over the next five
years. XYZ benefits if rates fall, stay flat (5%) or rise gradually.
◦ Below are two scenarios for this interest rate swap:
I. LIBOR rises 0.75% (rapidly) per year and
II. LIBOR rises 0.25% (gradually) per year.
Scenario 1 (interest rate swaps)
◦ If LIBOR rises by 0.75% per year, Company ABC's total interest
payments to its bondholders over the five-year period amount to
$225,000. Let's break down the calculation:

• In this scenario, ABC did well


because its interest rate was
fixed at 5% through the swap.
• ABC paid $15,000 less than it
would have with the variable
rate.
• XYZ's forecast was incorrect,
and the company lost $15,000
through the swap because rates
rose faster than it had expected.
Scenario 2 (interest rate swaps)
◦ In the second scenario, LIBOR rises by 0.25% per year (rise gradually):

• In this case, ABC would


have been better off by
not engaging in the
swap because interest
rates rose slowly.
• XYZ profited $35,000 by
engaging in the swap
because its forecast
was correct.
Other Swaps Example
Currency Swaps
◦ In a currency swap, the parties exchange interest and principal
payments on debt denominated in different currencies.
◦ Currency swaps can take place between countries. For example,
China has used swaps with Argentina, in order to stabilize
Argentine peso as well as to stabilize China’s foreign reserves.
◦ The U.S. Federal Reserve engaged in an aggressive swap strategy
with European central banks during the 2010 European financial
crisis to stabilize the euro, which was falling in value due to the
Greek debt crisis.
PURPOSE OF DERIVATIVES MARKETS
PRICE DISCOVERY

ü ability of the derivative markets to reveal about future cash


market prices.
ü represents the consequences of participants today about the
prices of a physical instrument in the future.
ü will also help the the investors to make better investment
decisions and prediction towards the future price of the
derivatives product.

HEDGING MECHANISM

ü enable the physical owners of a commodity to manage or


reduce their price risks systematically through achieving price
objectives
ü Price risks refer to the adverse price movements in the future
that will affect their exposure in the cash market.
Price Discovery
◦ Process of revealing the price information about derivatives price
and cash market price in the future.
◦ Table 1: CPO Future Price
Price Discovery (cont’d)
◦ Based on Table 1 , the information from price discovery process
are for the next four months the CPO price will increase (bullish)
and facing towards uptrend. After that, the price of CPO will
decline (bearish) further and moving towards downtrends.
◦ Therefore, traders and investors can easily predict the price of
cash market in the future.
◦ This, will help to enter the position and exit the current position.
◦ It also help the the investors to make better investment decisions
and prediction towards the future price of the derivatives
product.
Hedging Mechanism
◦ It used for the physical owner (producer/supplier) to manage the
price risk of the derivatives product that will decrease. (SHORT
HEDGE)
◦ Also used for the refiner (processer/ buyers) to manage the price
risk of the derivatives product that will increase. (LONG HEDGE)
◦ Price risks refer to the adverse price movements in the future that
will affect their exposure in the cash market.
◦ By hedging with the derivatives, they (buyer and seller) could
protect their trading profit from any undesirable risk and well as
achieve price objectives.
◦ Price objectives can buy at lower (buyer) and sell at higher price
(seller).
Futures Positions
◦ A long (buy) position futures hedge is appropriate when you
know you will purchase an asset in the future and want to
lock in the price today.
◦ Long hedge
◦ Long Speculating

◦ A short (sell) position futures hedge is appropriate when you


know you will sell an asset in the future & want to lock in the
price today.
◦ Short hedge
◦ Short speculating
MAJOR PARTICIPANTS OF DERIVATIVE MARKETS

1. HEDGERS
• are physical owners of the underlying
commodity who will use derivatives instruments
to protect their price risk exposure in the cash
market

2. SPECULATORS
• Traders who are attracted to the market in view
of profiting from the volatility of prices.

3. Spreader
4. Arbitrageur
EXCHANGE-TRADED VS. OVER-THE-COUNTER DERIVATIVES

Features of Derivatives Over-the-Counter Exchange-Traded


Trading
(Forwards, Swaps) (Futures, Options)
Market Place Not Centralized (OTC) Centralized (Exchange)
Regulation Self-Regulated / Private Securities Commission-
market Regulated Market
Trading Customized / Negotiated Standardized Contract
Contract (Bursa)
Transparency of Not Transparent Transparent - price
Contract report
Margins Payment No legal requirement Legal requirement
(deposit)
Credit/ Default Risk High risk Low risk
Guarantee of Contract No guarantee of Guaranteed by Bursa
Performance performance / Bad Clearing house / Good
Origin of Derivative Trading
◦ Modern textbooks in financial economics often misrepresent the
history of derivative securities.
◦ For example, Hull (2006) suggests that derivatives became
significant only during the past 25 years, and that it is only now
that they are traded on exchanges. “In the last 25 years
derivatives have become increasingly important in the world of
finance. Futures and options are now traded actively on many
exchanges throughout the world” (Hull 2006, p. 1).
◦ Mishkin (2006) is even more adamant that derivatives are new
financial instruments that were invented in the 1970s. He suggests
that an increase in the volatility of financial markets created a
demand for hedging instruments that were used by financial
institutions to manage risk. Does he really believe that financial
markets were insufficiently volatile to warrant derivative trading
before the 1970s?
Origin of Derivative Trading (cont’d)

◦ “Starting in the 1970s and increasingly in the 1980s and 90s, the world
became a riskier place for the financial institutions described in this
part of the book. Swings in interest rates widened, and the bond and
stock markets went through some episodes of increased volatility.
◦ As a result of these developments, managers of financial institutions
became more concerned with reducing the risk their institutions
faced.
◦ Given the greater demand for risk reduction (hedging), the process of
financial innovation (new derivatives asset) came to the rescue by
producing new financial instruments that helped financial institution
managers manage risk better. These instruments, called derivatives,
have payoffs that are linked to previously issued securities and are
extremely useful risk reduction tools” (Mishkin 2006, p. 309).
Structure and Development of Derivative
Market in Malaysia.
◦ Malaysia joined derivatives trading 1980, which first launched the
Crude Palm Oil Futures (FCPO) at Kuala Lumpur Commodity
Exchange.
◦ In 1995, Malaysia introduced KLCI future (index futures) at Kuala
Lumpur Options and Financial Futures Exchange.
◦ In 2004, the Bursa Malaysia was developed after merging of
exchanges in Malaysia.
1) Bursa Malaysia Stock Exchange
2) Bursa Malaysia Derivatives Exchange
3) Bursa Malaysia Derivatives Clearing.
Structure and Development of Derivative
Market in Malaysia (cont’d)
◦ Examples Development on Futures and Options
Contract in Bursa Malaysia Derivatives Exchanged
1) FCPO (Commodity CPO futures) - 1980
2) FKLI (KLCI index future) -1995
3) FKB3 (interest rate futures) - 1996
4) FMG5 (bond futures) - 2002
5) SSF (Single stock futures) - 2006
6) OKLI (Index Option) - 2000
7) FGOLD (Commodity gold futures) - 2013
8) FM70 (index futures) - 2018
J THANK YOU J

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