DERIVATIVES MARKET

When is a put option considered as out-of-money?

if the exercise price is lower than the price of the put option's underlying asset. For out-of-money, the option will not be exercised.

Examples of options traded on exchanges

- Kuala Lumpur Composite Index Options (OKLI) - SGX MSCI Singapore (SiMSCI) Options - SGX Nikkei 225 Index Options - SGX Eurodollar Options - KOSPI 200 Option - US Dollar Option - Hang Seng Index Options

The Key Elements of an Option

1. Strike price or exercise price - It is an agreed price at which the underlying asset is transacted if the option is exercised - The buyer will only exercise the option when circumstances favour it. ○If the strike price is more favourable than the prevailing price, such an option is described as in-the-money 2. Expiry date and option style Expiry date is the maturity date 3. Two types of option styles American style option ○Can be exercised at any time European style option ○Can be exercised only on the specified expiry date 4. Premium Cost or the price of an option ○The price that the option buyer pays to the option seller ○Premiums are quoted as index points to one decimal place Example: 1 point for RM100, 0.1 for RM10. If the premium is 25 points, then the price of the option is RM2,500.

Uses of Options

1.Investment in options provides leverage Purchase of option requires only payment of the premium which is usually a small percentage of the price of the underlying asset What about investment in shares? 2.Options can be used extensively in risk management Hedging ○The use of call and put options in the situation of rising and falling prices 3.To enhance portfolio returns Having some shares may allow an investor to sell call options to others to earn premium 4.Options are very flexible financial instruments Can be used to create strategies to take advantage of different situations 5.Options are used to manage information asymmetry A situation where both parties to the transaction do not have equal access to market information Attach put options with IPO

Speculating with Futures: 3 types of trades

1.Scalpers Look out for minimum price fluctuations on large volumes taking small profits at a time 2.Day traders Do intraday trading and on small volumes of trade 3.Position traders Look for long-term price trends and may hold on their position over weeks, or months

Hedging

1.Taking a future position in anticipation of a later cash transaction (anticipatory hedging) ○Example: the palm oil producer who intends to sell his palm oil in two months could lock in the price by selling the futures contract today ○If the future price of the palm oil decreases, .... ○The basic idea of hedging is to establish an opposite position in futures so that the gain from the futures position cancels out the loss from the underlying or physical market position 2.Taking a future position opposite to the current physical position held (hedging the current market position) ○Example: a fund manager with a portfolio of shares could hedge against a fall in share prices by selling stock index futures contract today ○When the fund manager locks in the price, if the future price of the index drops, the decline or loss in portfolio value is compensated by the gain from the futures position

Forward Contract

A contract between two parties agreeing to carry out a transaction at a future date but a price determined today Steps involved in buying crude palm oil: 1.Setting the price to be paid, exact specification of quality, quantity and delivery logistics, such as time, date and place 2.Delivering the crude palm oil from seller to buyer 3.Payment of cash from buyer to seller

When is a put option described as in-the-money?

A put option is said to be in the money if the current market price of the underlying security is below the strike price.

Speculating with Futures

A speculator is one who takes a position, believing he knows better than the market. Deal with price changes that occur in the market Try to make profit. Example: buy futures at a low price, then sell it at a high price Role of a speculator: provides the depth and volume of trading that allows hedgers and others to enter or exit the market easily Provide liquidity and continuous trading

Futures Contract

An exchange-traded form of forward contract A commitment to buy or sell an underlying asset at a future date Contracts are standardized ○Except for price - quantity, quality of the underlying asset, deliver date and location of delivery Traded electronically The price is determined based on the interaction between many buyers and sellers The counterparty risk is reduced through a clearing house Guarantees the performance of the parties in each transaction

When is a call option described as at-the-money?

An option is said to be at-the-money, if the exercise price equals the spot price of the underlying asset If this kind option is exercised, zero profit on exercise and loss on the price paid for the option (premium)

When is a call option described as out-of-money?

An option price is said to be out-of-money, if the exercise price is higher than the price of the call option's underlying asset

Arbitraging with Futures

Arbitrage is the practice of taking advantage of price differentials across different markets ○Simultaneous purchase and sale of the same instrument in different markets to profit from the temporary price differences ○Example: currency trading An arbitrageur is someone who buys and sells financial assets in order to make a profit from pricing anomalies. Arbitrageurs also play important role in providing liquidity and by ensuring the price of cash and futures converge at the expiry date of the contract.

Types of Options

Call Option ○A call option gives the option buyer the right (but not the obligation) to buy a specified asset at a specified price at or before a specified date. ○When the option buyer exercises the right, the option seller is obliged to sell the asset to the option buyer. Put Option ○A put option gives the option buyer the right (but not the obligation) to sell a specified asset at a specified price at or before a specified date. ○When the option buyer exercises the right, the option seller is obliged to buy the asset from the option buyer.

Derivative Products Traded on BMD

Commodity Derivatives Crude Palm Oil Futures (FCPO) USD Crude Palm Oil Futures (FUPO) Crude Palm Kernel Oil Futures (FPKO) Equity Derivatives FTSE Bursa Malaysia KLCI Futures (FKLI) FTSE Bursa Malaysia KLCI Options (OKLI) Single Stock Futures (SSFs) Financial Derivatives 3 Month Kuala Lumpur Interbank Offered Rate Futures (FKB3) 3-Year Malaysian Government Securities Futures (FMG3) 5-Year Malaysian Government Securities Futures (FMG5)

Example of Swaps

Example: Let say Fair Ltd borrows RM50 million at a floating interest rate of KLIBOR plus a credit spread of 0.5% payable in 5 years. Meanwhile, Adil Ltd borrows RM50 million at a fixed interest rate of 9% payable also in 5 years. Fair Ltd and Adil Ltd may agree to swap their liabilities whereby Fair will pay Adil a fixed interest of 9% and Adil will pay Fair a floating rate of KLIBOR plus 0.5%. Companies involved in the swap agreements are known as counterparties.

Options derivatives

Exchange-traded options Originate and traded on a formal exchange Most commonly are equity options Traded using electronic trading systems Settled through a clearing house (MDCH) ○Novation A process whereby it connects the two contracting parties Standardized except for the price Over-the-counter options Not traded through a formal exchange Arrange deals through telephone or on face-to-face meetings Able to negotiate as to quantity, quality maturity and delivery ○Higher credit risk

Common forms of derivative instruments include

Forwards, futures, options, swaps, credit derivatives or combinations thereof (as applicable).

The Development of Malaysian Derivatives Market

From 1980 - 1995, our derivatives market was confined mainly on the crude palm oil (CPO) futures traded on the Kuala Lumpur Commodity Exchange (KLCE) In 1995 - Kuala Lumpur Options and Financial Futures Exchange (KLOFFE), now known as Bursa Malaysia Derivatives Berhad (BMD) which is 75% owned subsidiary of Bursa Malaysia Berhad. 25% owned by CME. It provides, operates and maintains a futures and options exchange. BMD operates the most liquid and successful crude palm oil futures contract in the world On 15 Dec 1995, the first financial futures contract based on the KLSE CI was traded on KLOFFE May 1996 - Malaysia Monetary Exchange (MME) was set up to provide fixed income derivatives, namely 3-month KLIBOR futures contract In 1998 - KLCE + MME = COMMEX (Commodity and Monetary Exchange of Malaysia) Jan 1999 - KLOFFE became the subsidiary of KLSE June 2001 - KLOFFE + COMMEX = Malaysian Derivatives Exchange (MDEX) MDEX was renamed Bursa Malaysia Derivatives Berhad on 20 April 2004 BMD operates under the supervision of SC and is governed by the Capital Market and Services Act 2007 On September 17, 2009, BMD entered into a strategic partnership with Chicago Mercantile Exchange

Premium is quoted based on the sum of intrinsic value and time value

Intrinsic value is the profit that can be obtained on an immediate exercise ○Intrinsic value equals the amount where option is in-the-money ○The option in-the-money and out-of-money has zero intrinsic value ○Call intrinsic value and put intrinsic value? Time value refers to the value that arises from the probability that an option will become profitable before its expiry date ○As the option approaches expiry, time value reduces and becomes zero at expiry

How do we determine when we should buy (long) or sell (short) a futures contract?

It can be done in two ways: 1.To observe the hedge from the underlying position 2.To observe from the point of price risk. To protect from the rising prices, the trader should buy the futures contract. To protect against falling prices, the trader should sell the futures contract.

OPTIONS DERIVATIVES

It is a contract between a buyer (option buyer) and seller (option seller) in which the buyer of the option has the right but not the obligation, to buy or sell a certain asset at a certain price before a certain date. What is the difference between the "right" and "obligation"? Selling an option ("writing" an option) versus buying an option ("take") The option seller is obligated to perform according to the terms of the contract once the option buyer exercises the option

Advantages of options

Limited risk (applicable to buyers only) ○Option sellers have unlimited risk similar to future holders Flexibility ○Standard options provide flexibility to trade freely in the open market ○Improves liquidity and allowing prices to be more accurately priced

Example of Swaps (2)

Prima Berhad has excess THB that it will need in 6 months to pay for a capital project in Thailand. The Prima's treasurer wants to invest the THB in a short term instrument while able to use the funds in RM to cover some of the company's operating activities. In order to do that, Prima engages in a foreign exchange swap with its bank. It buys RM1,000,000 at a 8.7483 THB/RM exchange rate and sells 8,748,300 THB. At the same time, Prima agrees to sell back RM1,000,000 in 6 months at a rate of 9.00 THB/RM and buy back 9,000,000 THB. The difference between the spot rate and forward rate of 0.2517 represents the difference between THB and RM's interest rates over the 6 months period. This interest rate differential is equivalent to 251,700 THB.

Difference between options and futures

Right versus obligation ○Risk of loss is carried by the option seller ○The option buyer is protected from unfavorable market movements Fulfillment of the contract ○Futures -> both parties are obliged to transact at the same specified time in the future ○Options -> only one party is obliged to transact, when the buyer exercising the option.

Underlying assets

Shares, an index, a particular futures contract, currencies, gold etc. An index represents what?

Example of Futures

Sintok Palm Oil Bhd. produces 10,000 metric tonnes per month (120,000 metric tonnes per year). Due to global economic slowdown, Sintok Palm Oil Bhd. anticipates demand for crude palm oil will be lower. Bursa Malaysia Derivatives' Futures Crude Palm Oil (FCPO) contract allows the company to hedge up to 2 years forward by selling futures contracts. The company decides to hedge 50 percent of the production up to 6 months forward onto Bursa Malaysia Derivatives' FCPO. On April 2014, the company sells 5,000 metric tonnes of palm oil or 200 futures contracts (each FCPO contract is equivalent to 25 metric tonnes) in each month up to September 2015. Sintok Palm Oil Bhd. gains RM10.215 million from selling futures 6 months forward using the Bursa Malaysia Derivatives' FCPO contract. Note that the use of futures contract to hedge against the risk in the above example benefits the company, however, under certain circumstances, a company may lose from the hedging activities if the price turns out to be not as expected.

Transactions in the market:

Spot transactions ○Delivery happens on the spot Forward transactions ○Delivery happens sometimes in the future but the price and quantities are determined today.

History of Derivatives

Started as early as 1848 in the US Mainly concentrated in the commodity market 1919 - the establishment of Chicago Mercantile Exchange (CME), providing futures contract on various commodities Later, New York Mercantile Exchange and Chicago Board Options Exchange were developed Financial derivatives began to dominate trading during the 1970s In the early 1980s, most of the financial futures were traded in US But later, in the mid1980s to 2003, new exchanges were developed throughout Europe, South America and Asia Pacific region. The main reason for the change was because of the significant increase in net private capital inflows from the developed markets to the emerging markets. The link between the development of derivatives market and price variability of financial instruments is natural - risk management if there is risk

Disadvantages of trading futures contract

The futures contracts are standardized May prevent the hedger from benefiting from favorable price movements

Advantages of trading futures contracts

The minimum margin requirements allow traders to leverage their investments, that is, to trade many times more than the original cost of investment. A futures contract does not have to be held till it expires or matures. It can be closed out before the contract expires by making an opposite transaction. Low transaction costs

Hedging with Futures

The profitability of most individuals and corporations are affected by the changing prices of commodities and financial instruments ○Risk of price fluctuations (price risk) Futures markets provide a means of cancelling out the exposure to drastic price fluctuations in the underlying or physical market The purpose of hedging - to preserve the wealth A hedger is someone who buys or sells a financial asset to avoid risk.

How does the forward contract work?

Time to settle the contract in the future - expiration date Example: a rice farmer How long does it take to harvest the paddy? Price risk What is the price risk for the farmer? What is the price risk for the producer? Since both are facing the price risk, a forward contract can help them eliminating the price risk. How? A seller - short position A buyer - long position

Purpose of Futures Contract

To overcome 3 problems of forward contracts: 1.Multiple coincidence needs Match the underlying asset, delivery date or maturity and specified quantity 2.Unfair forward price The party who has better negotiating power may dictate unfair price 3.Counterparty risk One party may default which create losses to the other party

Example of Option

XYZ Corp. buys a 90-day option to buy US$100,000 at RM3.70 for a premium of RM2,000, which it plans to use as a hedge against a US$100,000 payment from a customer that is due in 90 days. At the end of the option contract, the spot rate is RM3.80. XYZ decides not to exercise the option because US$100,000 received from the customer can be exchanged into RM380,000 using the spot rate of RM3.80. Thus, XYZ has gained a net of RM8,000 (MYR380,000 - MYR370,000 - MYR2,000).

Swaps

a derivative instrument in which two counterparties exchange their financial instruments, such as a spot transaction on the over-the counter market that is executed at the same time as a forward transaction. It involves two transactions at once. For example, a currency is bought at a spot rate and date, and then is reversed at a forward rate and date. It depends on the type of financial instruments involved. For instance, if the swap involves swapping two bonds, the benefits involved may be in terms of swapping the periodic interest payments related to the bonds. Swaps can be used to hedge against certain risk such as interest rate risk. Swaps are customized bilateral transactions in which the parties agree to exchange cash flows at fixed periodic intervals, based on the underlying asset. Over-the-counter instrument Can be 1 month, 3 months, 6 months etc Each side of swap is called a leg Interest rate swaps

Derivatives are

financial assets or liability otherwise referred to as financial instruments whose value is derived from an underlying physical commodity asset, or index. In general, a derivative is a contract to buy and sell, which is set today but will be fulfilled at a stipulated date later for the purpose of managing exposure to financial market volatility. Derivatives are instruments created to minimize risk exposure. They are used as a tool for hedging, speculating and arbitraging. Their value are derived from something, such as asset, which could be from share prices, prices of commodity, indices and interest rates. If it is a commodity derivative, the underlying assets are commodities such as palm oil, coffee, wheat etc. If it is financial derivative, the underlying assets are financial assets such as debt instruments, currency, share price etc.