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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.
Spot Price
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
HEDGING MECHANISM
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
◦ “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