MAF 680 Chapter 7- Futures Derivatives (New)

8/17/2019 MAF 680 Chapter 7- Futures Derivatives (New)

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CHAPTER 7

FUTURES DERIVATIVES


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Describe a derivativeDescribe the history of derivative

Describe the development of derivative in Malaysia

Explain the difference between forward and futures contract

Explain terms convergence, margins and marking to marketand basis risk

Explain the terms hedging, speculating and arbitraging withfutures

Describe the contract specification of FCP and F!"#!now how to hedge, speculate and arbitrage using FCP

and F!"#

Explain and understand the term single stock futures

2

Learning Objectives


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Chapter Ot!ine

• Introduction to Derivatives• Forward and Futures Contracts

• The Key Elements of in Futures

Trading

• Hedging, !eculating and"r#itraging with Futures Contract

• The Crude $alm %il &FC$%' and K(CI&FK(I' futures

• ingle toc) Futures &F'

*


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"hat is a #erivative$

The word +derivative im!lies they derive theirvalue from something- It originates from mathematics and it is a varia#le

that derives from another varia#le- Derivatives on its own have little value #ut when it

derives from some other asset, )nown as the

underlying, hence, it has its value- The underlying can #e share !rices, !rices of

commodity, indices and interest rates- For e.am!le, a derivative of "ir "sia shares will

derive its value from share !rice of "ir "sia

&underlying'- imilarly, a derivative contract on Crude $alm %il

de!ends on the !rice of !alm oil and the derivativeof Kuala (um!ur Com!osite Inde. &K(CI' willde!end on the movement of the K(CI-

/


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Why do derivative marketsexist?

• (argely to facilitate hedging-

• The derivative mar)ets are largely

insurance mar)ets-• Firms, li)e individuals are ris) averseand would li)e to !rotect themselvesagainst three main ty!es of ris) that#usinesses face0 $ICE IK,CE3C4 IK and I3TEET "TEIK-

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SPOT MARKET vsFORWARD/FUTURES

MARKETS• In the s!ot &cash' mar)et, #uyers and sellers

agree on $rice &$' and 5uantity &5' forimmediate delivery &or within a few days'-

• E.am!le0 $roton #uys 1 million 6a!anese 4enin the s!ot mar)et for currency, or it #uys177 tons of steel in the cash mar)et for

steel- 8" #uys 977,777 gallons of gasolinein the s!ot mar)et-

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FORWARD COTRACT

• $rivate contracts #etween two!arties uyer and seller' for deliverysometime in the future &one month,one year'-

• 3ot mar)eta#le securities and thereis no secondary mar)et-

• E-g- li)e the di:erence #etween a#an) loan &not mar)eta#le' and a#ond &mar)eta#le'-

7


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Me!ha"i!s o# For$ard Co"tra!ts% A" i&&'stratio"

• "ssume there are 2 !arties ; a cocoafarmer who has !lanted cocoa on hisfarm and is e.!ecting to harvest the

cocoa in < months and a confectionerwho !roduces chocolate using cocoa!owder-

• "ssume further that the confectioner

has in his inventory, su=cient cocoato last him for the ne.t < months, #utwould have to re!lenish his stoc) at

the end of the si.th month- Clearly,#oth !arties here are e.!osed to ris),


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• The cocoa farmer faces the ris) that thes!ot !rice of cocoa could fall #etween now

and < months from now, when hecom!letes his harvest- uch a fall willo#viously reduce his revenue and !ro>ts-Infact, if the fall in s!ot !rice is shar!

enough, he could even face outrightlosses-

• The confectioner faces similar ris) #ut in

the o!!osite direction- The s!ot !rice ofcoca could increase #etween now and <months from now when he needs tore!lenish his inventory- "ny increase in

!rices will increase his costs and reducehis ro>ts-


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• ince #oth !arties face !rice?ris) and

neither !arty can tell which way !riceswould go, it would #e in their interest togo into an arrangement that could !rotectthem from this !rice?ris)- uch an

arrangement would #e the forwardcontract- nder the forward contract, thefarmer would agree to deliver and theconfectioner to ta)e delivery of cocoa of

an agreed @uantity on a mutuallyagreea#le date and at a !rice determinednow ; i-e- at the time of initiation ofcontract-


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Farmer

(Short position)

negotiate

Agree on :

Price, quantity, quality,

maturity delivery location

etc.

Farmer (Short position)

on!ection ("ongPosition)

The long position agrees to take delivery (buy) of the underlying asset while the

short position agrees to make delivery (sell).

The long position agrees to take delivery (buy) of the underlying asset while the

short position agrees to make delivery (sell).

Step 1 (at initiation of contract; day = 0)

Step 2 (on maturity date# day $ %&')

ocoa

oney

on!ection ("ong

Position)


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FORWARD COTRACTS (E)AMP*E +

• Aiant u!ermar)et enters into a forwardcontract in 8ay to !urchase rice at harvesttime in %cto#er, at a guaranteed !rice, from

various rice farmers for their entire cro!-• "dvantage0 #uyer &com!any' and seller&farmer' gave a guaranteed !rice- They arenow !rotected from !rice swings in rice-

• They have eliminated !rice ris) com!letely #yhedging their !osition, loc)ing in a !rice witha forward contract-

%


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FORWARD COTRACTS (E)AMP*E ,

• Toyota 8otors enters into a contractfor British !ounds with Ban) %ne, to

either #uy !ounds or sell !ounds, insi. months at a guaranteede.change rate- By loc)ing in, Toyota

8otors has hedged currency ris)-

%*


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Adva"ta-es/Disadva"ta-eso# For$ard Co"tra!t

• "dvantage0 They are very e.i#le and can #ecustomied to the needs of the !arties-

• Disadvantages0

+ There is no li@uid mar)et for forward contracts,no secondary mar)et-

+ $ro#lem in !rice >.ing- The !arty who has #etternegotiating !ower may dictate an unfair !rice-

+ High default ris)- %ne !arty may default &notful>lling the future o#ligation agreed u!onearlier', resulting in losses for the other !arty-

This ris) is )nown as counter!arty ris)-

+ e@uires actual delivery to com!lete the

contract-- %


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FUTURES COTRACTS

• "re the same in !rinci!le as aforward contract, where two !artiesuyer and seller' agree totradee.change something &rice,corn, oil, T?#ills, 4en' in the future&one wee), one month, one year',

#ut they agree on $ and 5 now, forfuture delivery, using a futurescontract from a futures e.change ;

an organied mar)et for trading %5


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"hat is a %tres c&ntract$

• exchange-traded form of forward contract• Basically to overcome * !ro#lems of forward

contract + &1' multi!le coincidence needs,

+ &2' unfair forward !rice and + &*' counter!arty ris)-

• Because they are e.change?traded, thecontracts are standardised-

• E.ce!t for price the standardised contractwould have s!eci>ed the @uantity &or thecontract sie', @uality &or the grade' of theunderlying asset, delivery date &or the e.!irydate' and location of delivery-

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M'&ti.&e Coi"!ide"!e o# eeds

• "t least three things must match #efore the two!arties in a forward contract can even #egin tonegotiate !rices-

(i) asset match

(ii) maturity match(iii) quantity match

• There could #e others such as delivery locationetc- The result is that there could #e su#stantial

search costsG involved- %ne !arty will have tosearch out the other there#y incurring costs interms of time, advertisement etc-


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• In such a situation, even if the cocoafarmer feels the !rice o:ered maynot #e fair, he may have little choice#ut acce!t the !rice- This would #e!articularly so, if the !roduct is!erisha#le and could s!oil shortly

after harvest- The short !ositiondoes not have much of an o!tion towait and see if he could fetch a

#etter !rice !ost harvest-


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Co'"ter.arty / De#a'&t

Risk • Counter!arty ris) or default ris), refers to the!ossi#ility that one of the !arties to thetransaction could default- uch default could

ha!!en not so much #ecause the !arty isdishonestG #ut rather due to the incentive todefault given changes in the s!ot !rice-

• However, if s!ot !rices su#se@uently #egin to

fall, the long !osition &confectioner' #egins tohurt since he has agreed to forward !rice#ased on the higher !revious s!ot !rice-


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• The o!!osite is true if s!ot !rices #egin to riseafter the forward contract is negotiated- 3ow,the short !osition, the farmer, #egins to hurt

since he would feel that his cocoa could now #esold at higher !rices- He would regret havingloc)ed himself into the +low forward !rice-

• e assume that the two !arties had agreed on

a forward !rice of 8177 !er ton- e e.aminewhat will ha!!en if say, the s!ot !rice onmaturity day is at 87 !er ton or 8127 !erton-


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Adva"ta-es o# #'t'res !o"tra!tsover #or$ard !o"tra!ts

• (i@uid mar)et, lots of #uyers and sellers atorganied e.changes all over the world-

• "ctive secondary mar)et- Contract may trade handsmany times #efore e.!iration-

• 8inimal ris)- The futures e.change re@uires aninitial margin to o!en a !osition and they enforcedaily settlement of all gains and losses to avoiddefault- There is ma.imum !rice movement, called

daily limit , to minimie large losses- For e.am!le,daily !rice limit for !alm oil futures is 17J a#ove or#elow the settlement !rice of the !receding#usiness day, trading sto!s for the day-


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Adva"ta-es o# #'t'res !o"tra!tsover #or$ard !o"tra!ts

• The counter!arty ris) is reduced through a clearinghouse which ta)e res!onsi#ility for ensuring thecontract is #rought through without any !artiesdefaulting in the transaction-

• Cash settlement for most futures contracts, insteadof settlement in the actual commodity-

• 4ou can close your account anytime #y ta)ing ano:setting !osition- If your original !osition is to #uy

&go long' a futures contract, you can su#se@uentlysell &go short' to close out your !osition, and viceversa- 4ou can cash out without having to ma)e orreceive delivery-

*


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Disadva"ta-es o# #'t'res!o"tra!ts over #or$ard !o"tra!ts

• (ess e.i#le since futures contracts are for>.ed, standard amounts, e-g- !alm oil futurescontracts are for 29 metric tons !er contract-

• E.!iration dates are >.ed0 E-g- 6an, 8arch,e!tem#er and Decem#er- &only few delivery!er year-

• The location for delivery are >.ed &$ort

Kelang, $enangButterworth and $asir Audang&6ohor'


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E'a(p!es &% %tres c&ntracts tra#e# in

)rsa *a!a+sia Derivatives )h#

• toc) Inde. Futures + K(CI &FK(I' Futures

• ingle toc) Futures &Fs'

• Interest ate Futures

+ * 8onth Kuala (um!ur Inter#an) %:ered ate interest rate&FKB*'

• Bond Futures + *?4ear 8alaysian Aovernment ecurities &F8A*' Futures

+ 9?4ear 8alaysian Aovernment ecurities &F8A9' Futures

+ 17?4ear 8alaysian Aovernment ecurities &F8A"' Futures• "griculture Futures

+ Crude $alm %il &FC$%' Futures

+ Crude $alm Kernel %il &F$K%' Futures

+ D Crude $alm %il &F$%' Futures

5


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The ,e+ E!e(ents &% Ftres Tra#ing

• Convergence of Futures and Cash$rices

• Basis and Basis is)

• 8argins and 8ar)ing to 8ar)et

• Ty!es of orders

• The Clearing House

2<


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Pri!e Co"ver-e"!e

• The futures !rice of a contract and the cash!rice &s!ot !rice of the underlying' of thesame commodity tend to converge, i-e- theywill come together as the delivery month ofthe futures contract a!!roaches- %n maturitydate, the futures !rice must e@ual s!ot !rice-

• hen futures !rice s!ot !rice L contango-

• hen futures !rice M s!ot !rice L

#ac)wardation-• Determined #y mar)et forces &ss and dd'

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The Co"ver-e"!e

Pro.erty• The convergence !ro!erty states that the!rice of a futures contract on the day ofits maturity must e@ual the s!ot !rice of

the underlying on that day-• The logic for this is that, on its maturity

day, a futures contract is essentially as!ot asset-

• The !ot $rice and the Future $rice must#e e@ual otherwise there would #e aris)less ar#itrage o!!ortunity- %ne could

even argue that the e.istence of suchar#itrage o!!ortunity would ensure


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S.ot1F't'res Co"ver-e"!e atMat'rity

FuturesSpot

aturity day

t

Spot-Futures Price


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2asis a"d 2asis Risk

• Basis is the di:erence #etween cash !rice

&or s!ot !rice', and Futures !rice, F-

• It reduces to ero at it a!!roachesmaturity of the futures contract-

• In a !erfect hedge, the gains or losses inthe futures contract e.actly o:set thelosses or gains of the underlying asset#eing hedged-

• If do not !erfectly cancel each other out, itis called basis risk - Due to mismatches of@uality &grade', location, maturity, @ty-

*'


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2asis a"d 2asis Risk

• The di:erence or s!read #etween thefutures and s!ot !rices is often )nown asthe basis- The #asis should e@ual the net

carrying cost-• The #asis narrows over time to reach ero

at maturity- $rior to maturity however, the#asis would #e !ositive or occasionallynegative-

oT t S F Basis −=

,


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• 2asis risk can #e thought of astrac)ing error- Basis ris) would #e!resent whenever there is any of

these three mismatches0

&i' "sset mismatch

&ii' 8aturity mismatch and

&iii' 5uantity &or contract sie'mismatch-

M i d M ki t


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Mar-i"s a"d Marki"- toMarket

• E.am!le0Consider an investor, contacts his #ro)er on Tuesday, 2nd of 6une to #uy two Decem#ercrude !alm oil futures contracts at Bursa

8alaysia Derivative Berhad- %ne futurescontract e@uivalent to 29 metric tons- Currentmar)et !rice is 82,777 !er ton-

Therefore, the investor is contracted to #uy 97metric tons at this !rice- The total value of thistransaction0

L 2 contracts . 29 metric tons . 82,777

L 8177,777

**


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Mar-i"s a"d Marki"- toMarket

• The #ro)er re@uires the investor to de!ositsome money in a margin account &initialmargin'- "ssume that the initial de!osit is817,777 !er contract L Initial 8argin L827,777-

• "t the end of each day, the margin account isadNusted to reect the investors gain or loss-

• This is the additional margin !ayments that

would have to #e !aid and is called thevariation maintenance margin-

• This !ractice is referred to as mar)ing tomar)etG or &mar)ed to mar)et'-

*


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Mar-i"s a"d Marki"- to Market

• "ssume that at the end of the day, the !alm oil futures !ricecloses at 81,O97 !er ton- This im!lies that the investor hasmade a loss L 2 contract . 29 metric tons . 8197 L8,977

• If the !rice for the following day closes at 82,*77 !er ton,

the #alance of the margin account will increase #y02 . 29 . 8/97 L 822,977

• Hence for the last two days, the margin #alance has #ecome8*9 777 L &827,777 ; 8,977 P 822,977'

• The investor is entitled to withdraw any #alance in the

margin ac in e.cess of the initial margin &I8' L 819 777• To ensure that margin ac does not #ecome negative, a

maintenance margin is set &usually lower than I8'-

• If the #alance falls M maintenance margin, the investor willreceive a margin call- He is e.!ected to to! u! the di:erence

#ac) to the initial margin the following day- *5


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DA3 Pri!e 4ariatio" -ai"/&oss 2a&a"!e

7 2777 $ay margin 27 777 27 777

1 1O97 &977' 12 977

2 2*77 /97 . 2 . 29 L 22977 *9 777

*6


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The C&eari"- 5o'se

• "cts as intermediary in futurestransactions-

• Auarantees the !erformance of the!arties in each transaction-

• To ensure none of the !arties arehurt #y the defaulting !arty-

*&


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Cr#e Pa!( Oi! -FCPO. Ftres an#

,LCI -F,LI. Ftres

• The nderlying Instrument of FC$%and FK(I

• The Contract !eci>cation FC$% ;refer to Ta#le -1 !age 1Q2

• The Contract !eci>cation FK(I ;refer to Ta#le -* !age 1Q<

*Q


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Trading $racticalities

• (ong ; #ought futures contract

+ Contract to receive deliverycontract to #uyunderlying asset

+ eg0 (ong 2 "ugust 2711 FC$% at 81777tonne

R Engage in contact to receive delivery of 97tonnes of C$% in "ugust 2711 at 81777tonneS

• hort ; sell futures contract

+ Contract to ma)e deliverycontract to sellunderlying asset

+ hort 2 "ug 2711 at 81777t

R Engage in contract to deliver 97 tonnes of C$%

in "ug 2711 at 81777tS '


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EECIE

• (ong * Dec 2712 FC$% U81,277

• T%D"40• " contract to #uy 9 tonnes of C$% in Dec

2712 at 81,277

• "t maturityDec 2712• B4 9 tonnes of C$% and !ay 81,277

$hysical settlement

• %

• E(( * Dec 2712 FC$% at !rice of Dec 2712FC$% traded in Dec 2712- cash settlement

%


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EECIE

• (ong "ugust FK(I U 1127

• Contract to #uy K(CI in "ugust U1127

• ETT(E8E3T + C"H ettlement

+ ell "ug FK(I U !rice of "A FK(Itraded in "ug-


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Forwards, FuturesV Wero sum Aame

• In a world of limited>nite resources, most>nancial transactions, including allderivatives transactions are ero?sumgamesV that is one !artys gain is at

another !artys e.!ense-if spot prices rise$ro>t to (ong L !ot !rice at 8aturity ;%riginal Futures $rice

(the short position’s implied loss equalsthis amount)if spot prices fall $ro>t to hort L %riginal Futures $rice ;

!ot !rice at 8aturity-’


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Ty.es o# F't'res Markets Parti!i.a"ts

• Hedgers

• !eculators

• "r#itrageurs


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5ed-ers

• Futures traders who have a !ersonalor #usiness interest in the futurecommodity !rices, e.change rate or

interest rate-

• E-g- im!orterse.!orters,cor!orations #uying and selling in

the future, farmers, !ortfoliomanagers, >rms e.!ecting to #orrowmoney in the future, >rmsinvestors

e.!ecting to invest money in the 5


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5ed-ers 1 Exam.&es

• Farmers &sellers' and !roducers are worrieda#out the !rice of their !roduct going down inthe future- They can use futures contract toloc) in !rice now for future out!ut of oil, corn,wheat, sugar, steel, gold etc #y going H%T on contracts for their !roduct-

• E.!orters &im!orters' receiving foreigncurrency &!aying in foreign currency' canhedge ris) #y going short &long' on currencyfutures-

6


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• Aiven the K(CI is 1797 and the value of a!ortfolio is 8* million- If the !ortfolio managerwishes to hedge O7J against a !rice decrease,

how many contracts will the !ortfolio managerhave to tradeX Does the trader #uy or sellX

• u!!ose in Fe#ruary, a !alm oil !roducer

antici!ates that he will have 1O7 metric tonnesof crude !alm oil ready for sale in four monthstime- He would li)e to >. the !rice for his!roduce- The current mar)et !rice &Fe#ruary' of

the !alm oil is a#out 82,297 !er metric tonnewhile the 6une crude !alm oil futures &FC$%'iscurrently trading at 82,2


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Ty.es o# 5ed-i"- Hedging is ta)ing a &1' future position in

antici!ation of a later cash transaction or &2' ta)inga future !osition opposite to the current !hysical!osition held-

The former ty!e is )nown as anticipatory hedging and the latter ty!e is )nown as hedging the current

market position- "n e.am!le of antici!atory hedging is the !alm oil!roducer who intends to sell his !alm oil in 2months could loc) in the !rice #y selling the futures contract today .

"n e.am!le of hedging current market position is

the fund manager with a !ortfolio of shares couldhedge against a fall in share !rices #y selling &ta)ing a futures !osition opposite to the current

position of holding a !ortfolio of shares' stoc) inde.futures contracts today-

&


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trategy

• 3um#er of contracts

• Contract 8onth

•"ction


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Ty.es o# 5ed-i"-

• anticipatory hedging + ? efer to Ta#le -9 !age 1QQ

• hedging the current market position

97


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A" A"ti!i.atory 5ed-e

• %ften, !roducers may not have an immediate !osition in

an underlying asset #ut a !otential !osition- That is, theyantici!ate having a !osition in the underlying asset at afuture !oint-

• "ssume that the farmer is e.!ecting to !roduce 127 tonsof cocoa in < months and wishes to hedge his !rice?ris)-

u!!ose further that cocoa futures are maturing in


51/89

• Each !arty could do their hedging through thefutures mar)et as follows- The farmer would callhis futures #ro)er and short &sell' 12 cocoa futuresfor < month delivery while the confectioner would

instruct his #ro)er to long 12 such contracts-

• "t this !oint #oth !arties would #e fully hedgedsince in < months the confectioner )nows he willhave to !ay e.actly &81,777 . 12' L 812,777

for the 127 tons of cocoa he needs while thefarmer is assured of 812,777 as !ayment for hiscocoa-


52/89

• 3otice that neither !arty needs to )nowwho the counter !arty is- 4et, each !artyis assured of delivery!ayment #ecausethe e.change &through its clearing

house' #ecomes the counter !arty to#oth the farmer and confectioner-

• %n registration of the trade, theclearinghouse guarantees the

transaction- "ssuming #oth !arties holdtheir !osition to maturity, the cocoafutures contract will #e settled on itsmaturity day &day 1O7' as follows-


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/0change1esignated

2arehouse

ocoaFarmer

(short)

/0change(learing3

house)

on!ectioner("ong)

Payment

()

ocoa

2arehouse

receipt

()

(5)

(6

)

Settlement of A Futures Contract

Numbers within brackets show the sequence of events

(*) 4. receipt

Payment

()

(*) 4. receipt

ocoa

2arehouse

receipt(%)


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Exam.&e

• u!!ose in Fe#, a crude .a&m oil !roducer antici!ates

that he will have 277 metric tons of crude !alm oilready for sale in two months time- He would li)e toloc) in the !rice of his crude !alm oil- The current m)t!rice &Fe#' is 81,297 !er metric ton- "!ril crude

!alm oil futures is currently trading at 81,2


55/89

• "ssume in "!ril the !rice of crude !alm oil inthe s!ot mar)et has dro!!ed to 81,2/9ton-o has the "!ril futures &!rice convergence'-

• The !roducer sells the C$% in the s!ot mar)etfor 81,2/9 and also closes out the futures!osition #y #uying &long !osition' O futurescontracts at 81,2/9-

56

S'mmary o# the


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S'mmary o# the.ositio"s%Positio" Today Positio" at Mat'rity 6ai"s/*os

s

Cash 8)t 8)t !rice L 81,297 8)t !rice L 81,2/9"ction0 se&&s 277 tonsat 81,2/9- Total sales L 277 .81,2/9 L 82/Q,777 82/Q,777

Futures8)t

8)t !rice L 81,2


57/89

Exam.&e• u!!ose in 8ay, a crude !alm oil re>ner receives an order

for a O77 met tons of re>ned $% to #e delivered in e!t-He would li)e to loc) in the !rice of his crude !alm oil- TheC$% futures for delivery in e!t is trading at 81,27-

• Current s!ot !rice L 81,2c num#er of

contracts at a certain !oint in future

• L O77 tons29 L *2 C$% e!t futures contracts at81,27-

• &he needs to !ay only the initial margin'• This gives con>dence to the oil re>ner to @uote the !rice to

his customers using )nown $% cost-

5&


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Exam.&e

• In e!t, he !urchases the O77 met tons of C$%in the s!ot mar)et at 81,2O

• He closes out the futures !osition #y selling

&short !osition' *2 futures contracts at thecurrent m)t !rice of 81,2O-

5

S # th iti


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S'mmary o# the .ositio"s%Position Today Position at Maturity ains!"oss

ash t t price $ %,65he re!iner needs &'' mettons o! P8 in Sept.

t price $ %,7& 9ction# $uys %'' tonsat %,7&.otal costs:$ &'' 0 %,7&$ %,','' (%,','')

Futures t t price $ %,7' 9ction: $uy futures$ * contracts at %,7'otal value o! !utures$ * 0 5 0 %,7'$ (%,'%6,''')

lose its position ;yselling * !uturescontract


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SPECU*ATORS• Have no !ersonal or #usiness interest in the

commodity or currency- They are trading futurescontracts as a !urely s!eculative investment orgam#le-

• For e.am!le, an investor could ta)e a !osition on

a !alm oil futures contract for 8arch 277Q U81,297 !er metric ton, and they are not in the!alm oil #usiness, they have no interest inactually receiving or delivering !alm oil at

e.!iration- They are Nust ta)ing a !osition on the!rice of !alm oil in the future-

• !eculators can !artici!ate in futures trading#ecause actual delivery is not re@uired-

6%

SPECU*ATORS


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SPECU*ATORS 1E)AMP*E

• If a s!eculator thin)s that the cash !rice of!alm oil will go a#ove 81,297 sometime#etween now and 6une 277Q, they ta)e a(%3A $%ITI%3, and #uy !alm oil futures

contracts- They are s!eculating that the$ 81,297, and will ma)e money if thatha!!ens- They #uy U81,297 and ho!eto sell at $ 81,297- !eculator isgam#ling etting' that the !rice of !almoil will #e 81,297-

6

SPECU*ATORS


62/89

SPECU*ATORS 1E)AMP*E

• If the s!eculator thin)s that the cash!rice of !alm oil will go #elow81,297metric ton, he will ta)e a

H%T $%ITI%3, and sell !alm oilfutures- He will ma)e money if

$ M 81,297, they are #etting that

the !rice of !alm oil will fall-

6*


63/89

Spec!ating /ith Ftres C&ntract

!eculators deal with !rice changes thatoccurred in the mar)et- They are motivated #y the strong desire to

ma)e !ro>t on the transaction- They will #uy the futures at low !rice and

sell at high !rice- The s!eculative traders in the futures mar)et

hel! to ful>l a very im!ortant role- They!rovide the de!th and volume of trading that

allow hedgers and others to enter or e.it themar)et easily-

6

Three ty.es o# s.e!'&ators


64/89

Three ty.es o# s.e!'&ators

+ The scalpers loo) out for minimum !rice

uctuations on heavy &large' volumes ta)ingsmall !ro>ts at a time- They aim to ma)e small!ro>ts on large volumes of transaction-

+ The day traders do intraday trading and on

small volumes of trade- The ty!ical day traderwould ta)e long or short !ositions of a fewcontracts and would close?out their !ositionslater in the day when the !rices have moved-

+ The position traders loo) for long?term !rice

trends and may hold over wee)s, or months#efore getting out-

65


65/89

Using CPO Ftres t& Spec!ate

• %utright !osition s!eculative strategy

+ Ta)es a view of the change of the futures

!rices and s!eculate on it

+ ; refer to section -9-/-1 !age 272

• !read trading s!eculative strategy + Based on e.!ectations of changes in

relationshi! #etween several futurescontract

+ ; refer to section -9-/-2 !age 27*


66/89

EECIE0

• " trader ta)es a view that 8arch FK(Iwhich are currently trading at 119O-< area#out to enter a downtrend-

+ hould the trader go long or short futures- + "ssuming that the trader maintains his

!osition until e.!iry and the cash settlement!rice is 1129-/, what will #e the !ro>tloss-

• $ro>t L &119O-


67/89

EECIE

• " !alm oil !roducer >rmly #elieves

that the !rice of crude !alm oil isa#out to enter an u!trend- It is now%cto#er and the trader #uys <

3ovem#er C$% futures at 81,*7- The margin for C$% is 8O,777 !ercontract-

• Calculate !ro>t and loss on thetransaction if the trader decides toclose the contracts on day 9- The

!rice of FC$% on day 1,2,*,/, and 96&


68/89

EECIE

• u!!ose in 8arch, the "!ril FC$% contract istrading at 81,229 while the 8ay contract istrading at 81,177- "ssume that #etween8arch and "!ril, FC$% fell @uite shar!ly- Thetrader antici!ates that the s!read to #enarrowed-

• %utline the strategy that the trader should ta)e-

• "ssume that "!ril FC$% is traded at 811/7u!on maturity, calculate the !ro>tloss if thes!read #etween "!ril FC$% and 8ay FC$% is 7!oints-

6


69/89

• !read 3arrow

• Buy 8ay FC$% and ell "!ril FC$%

• $ro>t(oss L &1217?1177' P &1229?11/7' L 1Q9 29

L /O9

7'

%5

%%''

Spread 7' points

Price

ime

Arbitraging /ith Ftres C&ntract


70/89

Arbitraging /ith Ftres C&ntract

$rbitrage is simultaneous purchase and sale of the sameinstrument in different markets to profit from thetemporary price differences or inconsistencies%

&ow did arbitrage ensure price convergence'

$n arbitrage is a trade that involves buying in the

physical market and selling at the futures market at ahigher price%

$ trader who initiate the arbitrage if observes the pricesare traded above the (fair values) will act on by sellingthe futures where the prices are high and pushes the

price back to the fair value as determined in the physicalmarket%

Provide li*uidity and ensuring the price of cash andfutures converges at the expiry date of the contract%

7%

Fair va!e &% %tres price sing c&st &%


71/89


carr+ (e!

t ycr S F +- −++=

7

4hereF $ !utures price !or a contract 4ith maturity !rom

time t to T at maturityS $ cash or spot price o! the underlying assetr $ annualised ris3!ree interest rate (a pro0y !or

opportunity cost)c $ annualised cost o! storage (>) (inclusive o!

shipping, handling, shrinage, spoilage or damaged,etc)y $ convenience yield on the cash commodityt $ time to !utures e0piry e0pressed on yearly

;asis



72/89


carr+ (e!

• E.am!le0

• !ot !rice L 81,29

• torage L 89 !er month

• is)?free rate L /J• 1?month Futures contract L 81777

• Theoretical Fair !rice0F L 81,29 &1 P 7-7/ P 9.121,29' *7*


73/89

• Is it !ossi#le to ma)e a gain if theactual futures !rice is lower than the

fair !riceX If so, descri#e the strategya trader could use in this situation-

• If the 1?month FC$% is traded at

81977- Calculate the $( if any-

7


74/89

Using CPO Ftres t& Arbitrage

• Find the fair value of the futures !rice

• If the actual futures !rice fair value,over!riced !osition ; sell futures and #uy thes!ot or !hysical mar)et

• If the actual futures !rice M fair value,

under!riced !osition ; #uy futures and sell thes!ot or !hysical mar)et

• "n illustration of how to calculate fair value ofthe C$% futures ; !age 27/

• Ta#le - shows the outcome of ar#itraging-

9


75/89

E.am!le

• In 8arch, the s!ot !rice for C$% is8Q9- If the cost of storage is 8 9 !ermonth and the ris) free rate is 9J, what

is the u!!er limit for the "!ril futures!rice assuming the contract e.!ires inone monthX

• FY L Q9&R1P&7-79 'S P R&9Z12Q9'S'*7*


76/89

"ssume that "!ril FC$% are currently tradingat 81777 !er tonne-

• "r#itrage o!!ortunity e.ist co "!ril futures

are not correctly !riced, %YEY"(E• trategyV

TodayV

ell "!ril FC$% at 81777t co overvalue

Buy C$% at 8Q9tV store at 89 !er month-

!on maturity, deliver C$% to #uyer andreceive 81777t-

$ro>t0 1777 ; Q9 ; 9 L 827t

77


77/89

EECIE

• Today is early %cto#er- 4ou #elievethat @uotations of FK(I aremismatched- Currently the s!ot

inde. is @uoting at QQ7 while3ovem#er FK(I at 17


78/89

t ycr S F +- −++=

7

F $ ' (%? 6.5> ? ' + *.5>)6%-*65

F $ .'

8verpriced:

oday: Sell =ov F@"A < %'6'

Buy 5 million shares < '. Cold temporarily

"ater: Buy =ov F@"A < %''

Sell shares that 4orth

( 5 ? ( %''3'-')5$ 5%5%5%5.%5

#i >


79/89

"r#itrage $ro>t

Des!ri.tio" Pro=t

Futures $ro>t &17


80/89

EECIE

• 4our #an) is willing to >nance the!urchase of !hysical shares for *8through ar#itrage activity- 4ou

o#serve that the s!ot inde. iscurrently trading at Q


81/89

• 3o of Contract L *8 &17OO . 97' L 99 contracts

• Today + ell 99 6uly U 17OO

+ Buy 8 *8 shares on a #orrowed funds CI Q


82/89

E.am!leV

• u!!ose you o#serve the following @uotations today-• *?month FK(I !rice L 1,217• Inde. value L 1,277 !ts• rf rate L /J• Dividend 4ield L 2J• Time to maturity of IF L Q7 days

• To see if ar#itrage is !ossi#le we >rst chec) formis!ricing- The correct value of the *?month FK(Ishould #eV

• Ft L 1,277 &1P-7/?-72'7-29L 1,277 &1-72'7-29L 1,279-Q< !oints


83/89

Aiven the a#ove information, the futures is clearly over!ricedrelative to s!ot- The futures !rice should #e 1,279-Q< !oints,yet it is @uoted at 1,217 !oints- %ver!riced #y a!!ro.imately /!oints-

Si"!e there is mis.ri!i"-, ar#itrage is !ossi#le- By using thefollowing ar#itrage strategy a ris)less !ro>t can #e made-

&3ote that no cash outlay is needed today

4e 4ill loo at maret scenarios. (Note: current stock index value is 1,2 !ts"

•

Ande0 ises to 122* at maturity• Ande0 Falls to 11* at maturity


84/89

S!e"ario +% >"dex Rises to +,,8Cash Carry Ar7itra-e

Action PositionToday

Position AtMaturity

Profit!"oss

(A) Short % F@"A

ontract

6',5''

(%%' 0 5')

(6%,5') (75')

(A) "ong Spot (6',''') 6%,5' %,5'

(A) Borro4 6','''< > !or ' days.

6',''' (6',5%.') (5%.')

(A) eceive divs. andinvest it < > !or 'days.

' *'* *'*

=et $ %%.&'


85/89

S!e"ario ,% >"dex Fa&&s to ++@8Cash Carry Ar7itra-e

Action PositionToday

Position AtMaturity

Profit!"oss

(A) Short % F@"A

ontract

6',5'' (5&,75') %,75'

(A) "ong Spot (6',''') 5&,75' (%,5')

(A) Borro4 6','''< > !or ' days.

6',''' (6',5%.') (5%.')

(A) eceive divs. andinvest it < > !or' days.

' *'* *'*

=et $ %%.&'


86/89

Reverse Cash a"d Carry Ar7itra-e

u!!ose in the a#ove e.am!le, the Futures !rice today is @uotedasV

*?month IF !rice L 1271

3ow, the IF is '"der.ri!ed relative to s!ot- In order toar#itrage we need to do the reverse of the earlier strategy

The following reverse Cash and Carry ar#itrage would #ea!!ro!riate here


87/89

>"dex Rises to +,,8

Action PositionToday Position AtMaturity Profit!"oss

(A) "ong % SAF ontract 6','5' 6%,5' %,''

(A) Short Spot 6',''' (6%,5') (%,5')

(A) "end 6',''' <> !or ' days.

(6',''') 6',5%.' 5%.'

(A) Borro4 *'' <

> to replace divs.on ;orro4ed shares(shorted).

' (*'*) (*'*)

=et $ *&.'


88/89

>"dex Fa&&s to ++@8

Action PositionToday Position AtMaturity Profit!"oss

(A) "ong % SAF ontract 6','5' 5&,75' (%,*'')

(A) Short Spot 6',''' (5&,75') %,5'

(A) "end 6',''' <> !or ' days.

(6',''') 6',5%.' 5%.'

(A) Borro4 *'' <

> to replace divs.on ;orro4ed shares(shorted).

' (*'*) (*'*)

=et $ *&.'

Si ! St 0 F t SSF B


89/89

Sing!e St&c0 Ftres SSFsB

• Fs are #ased on individual stoc)s listed in Bursa 8alaysia andtherefore, it trac)s the movement of

the individual underlying stoc)-• "s of now, there are Q F contracts-

• The contract s!eci>cation ; refer to

Ta#le -17 !age 21*-

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MAF 680 Chapter 7- Futures Derivatives (New)

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