COURSEBOOK
EDITION 2020
IRA MAZLIANA MHD ATAN
ZURAIDA MOHAMAD
TOPICAL
ASSESSMENT
&
PAST EXAM
QUESTIONS
INCLUDED
FOR UiTM STUDENTS
FUTURES AND OPTIONS (FIN379)
UNIVERSITI TEKNOLOGI MARA
Syllabus
Code
: FIN379
Course
: Futures and Options
Level
: Diploma
Credit Unit
: 3
Contact Hours
: 3
Part
: 5
Course Status (Core/Non
Core)
: Core
Pre-Requisite
: None
Course Outcomes
At the end of the course, students should be able to :
1.
Distinguish the various types of futures and options in Malaysian derivatives market.
(C2,P1,A2) (LO1)
2.
Apply the mechanisms of hedging, arbitraging, speculating and spreading in futures
trading. (C3,P3,A3) (LO2)
3.
Construct the basic and synthetic strategies for options trading. (C3,P3,A3) (LO3)
Course Description
This course exposes the students to the various types of futures and options in Malaysian
derivatives market. Mechanisms of futures trading and the strategies for options trading are
introduced that could be applied by the students in the real derivatives market.
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FUTURES AND OPTIONS (FIN379)
Syllabus Content
Topic
Page
Number
1.0 Introduction to Derivatives
1.1
1.2
1.3
1.4
1.5
Definition and Overview of Derivatives
The Exchange (Malaysia Derivative Exchange - MDEX)
The Clearing House (Malaysia Derivative Clearing House - MDCH)
Intermediaries in Bursa Malaysia Derivative Berhad (BMDB)
Users and Participants of Derivatives
5
8
8
9
9
2.0 Introduction to Futures
2.1
2.2
2.3
2.4
2.5
2.6
How the Futures Market Works
Basic Requirements
Contract Specifications
Physical & Cash Settlement
Margin & Type of Spread
Other Terms
12
13
13
14
15
16
3.0 Commodity Futures
3.1
3.2
3.3
3.4
Crude Palm Oil Futures (FCPO)
Hedging with FCPO
Speculating and Spreading with FCPO
Arbitraging with FCPO
19
21
27
36
4.0 Equity Futures
4.1 Kuala Lumpur Composite Index Futures (FKLI)
4.2 Hedging with FKLI
4.3 Speculating and Spreading with FKLI
4.4 Arbitraging with FKLI
5.0 Interest Rate Futures
5.1
5.2
5.3
5.4
Kuala Lumpur Inter Bank Offer Rate Futures (FKB)
Hedging with FKB
Speculating and Spreading with FKB
Arbitraging with FKB
6.0 Bond Futures
6.1 Malaysian Government Securities Futures (FMG)
6.2 Hedging with FMG
6.3 Speculating and Spreading with FMG
6.4 Arbitraging with FMG
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42
43
51
56
63
64
69
70
78
79
84
85
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FUTURES AND OPTIONS (FIN379)
INTRODUCTION TO FUTURES AND OPTIONS | MALAYSIAN DERIVATIVES
7.0 Introduction to Options
7.1
7.2
7.3
7.4
Definition of Options
Types of Options
Key Elements of Options
Option Pricing and Moneyness
88
89
89
90
8.0 Option Strategies
8.1 Basic Strategies:
Long Call and Long Put
Short Call and Short Put
8.2 Synthetic Strategies:
Straddle
Strangle
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94
94
98
106
106
110
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FUTURES AND OPTIONS (FIN379)
1.0 INTRODUCTION TO DERIVATIVES
1.1
Definition and Overview of Derivatives
• Traditional definition of market is a place where the
buyer and seller meet together to transact a business
which requires a buyer to take a delivery of a good
upon payment.
Market
• Taking and making deliveries of goods and exchange of
cash will happen immediately
• Buyer and seller must meet at one designated place.
Cash Market
Also known as a SPOT market (spot
transaction)
Requires immediate delivery of goods
(physical or financial assets) by a seller
and payment by a buyer
Derivative Market
Buyer and seller can delay a delivery of
goods and cash at a later date (expiry
date), through derivative market
In this kind of market, buyer and seller
do not have to meet at a physical
place and also without spot
transaction.
The Structure of Malaysian Financial Market
FIN 379
will
be
focusing
on
this
part!
Money Market
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Capital market
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FUTURES AND OPTIONS (FIN379)
Derivative are derived from the underlying (original)
instrument. The price of derivative instrument is
derived from the actual price of underlying, either
from the physical asset or financial asset.
By trading definition, derivative is simply a contract
to buy and sell which is set TODAY, but will be
fulfilled at a stipulated date, LATER.
It requires the two instruments and two markets
Derivative Market
derivatives and physical instruments
derivatives and physical markets
In view of the presence of the underlying instrument
and the market, both prices tend to influence each
other. Therefore the performance of the derivative
market depends on the performance of the physical
market
Types of Derivative Market
Forward
Futures :
: The oldest type of derivative market.
An agreement to buy and sell a
specified security at a specified price to be delivered at
the maturity date in the future.
: The presence of the third party to act as a guarantor, namely the clearing
house which will become a buyer for every seller and vice-versa (novation
process)
: regulated standard agreement obligating a buyer and seller to fulfill their
contracts
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FUTURES AND OPTIONS (FIN379)
Options : It is a contract that gives a right without obligation to a buyer, while the seller has
an obligation if requested
by a buyer, to buy or sell a specified security at a
specified price and time.
Swap
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: It is a private agreement to swap or exchange a specified security for specified
cash flow.
:Generally arises due to the need of international business between the two
countries.
: Common type of swap – currency and interest rate swap.
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FUTURES AND OPTIONS (FIN379)
Purposes of Derivative Market
Purpose
Details
The ability of the derivative markets to reveal information
about future cash market prices. It means that the consensus
of market players today about direction of prices of a physical
instrument in the future, therefore the investors can easily
discover the likely price in the future by referring to the
derivative today.
Price Discovery
A means of protection against undesirable price movements
for future commitment. By hedging with derivative
instruments, investors could protect their trading profit from
any undesirable risks, and hence, achieve their price objective.
The derivative market will be used as a temporary measure of
Hedging Mechanism
selling futures today and anticipating of selling physical later,
or buying futures today in anticipating of buying physical
later.
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A seller will SELL futures today in anticipating of FALLING
prices, while a buyer will BUY futures today in anticipating of
RISING prices.
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FUTURES AND OPTIONS (FIN379)
1.2
The Exchange (Bursa Malaysia Derivative Berhad – BMDB)
Formerly known as Malaysian Derivatives Exchange (MDEX). Bursa currently has a single
derivative exchange offering several derivative contracts. BMDB trades both commodity and
financial derivatives.
Below provides a brief overview of the historical evolution leading to the establishment
of BMDB.
The Malaysian Derivative market can be categorized into forward, futures, options and
swaps.
Controlled by the Ministry of Finance
Regulated by Security Commission
Malaysian Derivative Exchange act as operator of an exchange market and
Malaysian Derivative Clearing House is an operator of a clearing house
The Development of Derivative Market
1980 – KLCE – traded the Crude Palm Oil (CPO) futures, rubber, tin and cocoa
1995 – KLCI futures at the KLOFFE
1996 – KLIBOR at the Malaysian Monetary Exchange (MME)
2000 – KLCI Options
2002 - Bond futures (MGS)
2005 – KLSE into Bursa Malaysia Securities Berhad (BMSB)
MDEX to Bursa Malaysia Derivative Berhad (BMDB) and
Bursa Malaysia Derivatives Clearing as Malaysian Derivative Clearing House
(MDCH)
2006 – BMDB trades CPO, KLCI Futures, 3 month KLIBOR, KLCI Options and 5 year MGS futures
1.3
The Clearing House (Malaysia Derivative Clearing House –MDCH)
MDCH main objective is to do the clearing activities which included of identifying who
has bought, who has sold, what amount, who needs to pay, who needs to deliver, etc.
A clearing house plays two key roles :
Record keeping
Registers all trades that take place on the exchange
Risk management
Customers might face with counterparty risk (default risk by other party), clearing house
will become a buyer to very seller and a seller to every buyer to make sure that the
counterparty risk is eliminated. This process is called NOVATION.
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FUTURES AND OPTIONS (FIN379)
1.4
Intermediaries in Bursa Malaysia Derivative Berhad
MDCH
As mentioned above, through novation, MDCH imposed itself as an intermediary in every
transaction done through the exchange. It will act as;
BUYER to every SELLER and
SELLER to every BUYER
Broker
Broker has to clear the trade with the clearing house. On the other hand, the broker does it
directly if the broker is a clearing member.
1.5
Users and Participants of Derivatives
Hedgers
Speculators
Spreader
Arbitrageur
Actual owners of a commodity who will use a derivative
instruments to protect their price risks exposure in the cash
market (manage against the unfavorable price movement).
They have (or intend to have) a position in the underlying
instruments (to be discussed later)
Fictious owners of physical commodity because they do not own
or have intention to own such commodity or instrument.
Therefore, they are so much concern about speculating the price
movement in order to make a profit.
By speculating, the speculators are exposed to quick and big
profit when the market favor them, and vice-versa.
A Speculator who has dual positions or contracts at one time
(means taking two opposite positions simultaneously – buying
one contract and selling the other in the same or different futures
market.
A Speculator who has dual positions at one time, (buying futures
and selling physical, and vice-versa)
This strategy attempts to take advantage on the temporary
mispricing of two related instruments and hence, the least risk
Oopps!!! Before going any further,
could you be able to distinguish
between the spreader and arbitrageur?
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FUTURES AND OPTIONS (FIN379)
SELF-ASSESSMENT TASKS
1) In your own words, explain what is meant by derivative market ?
2) Briefly explain the following types of derivative market ;
i. Futures
ii.
Options
3) What do you understand by the term “Novation”
4) Distinguish between hedgers and speculators.
Hedgers
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Speculators
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FUTURES AND OPTIONS (FIN379)
PAST EXAM QUESTIONS
1. Define the futures and options contracts as parts of derivatives market. (5 marks)
Feb 2020
2. Describe any two (2) users of futures and options . (5 marks)
May 2017
3
. 3. Explain any two (2) functions of clearing house as a guarantor. (5 marks)
Dec 2016
4
.
. 4. Discuss the importance of the speculator in the future market. (5 marks) Mar 2016
5
. 5. Differentiate ‘futures’ and ‘options’ contract. (5 marks)
Mar 2015
5
. 6. (a) Define the following terms :
Sep 2013
I.
II.
III.
Speculators (2 marks)
Hedgers (2 marks)
Spreaders (2 marks)
(b) Differentiate between forward contract and future contract. (4 marks)
7. Discuss any four (4) roles of the clearing house in the futures market to ensure efficiency of
trading between the buyers and sellers. (8 marks)
Sept 2011
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FUTURES AND OPTIONS (FIN379)
2.0 INTRODUCTION TO FUTURES
2.1
How the Futures Market Works?
A contract to buy or sell a specified security (or commodity) at a specified price and
time agreed today but to be fulfilled in the future date (maturity date).
Eg:
Today (Jan)
Later (March)
BMDB
BUY (number of contract)
(types of instrument) at
(price)
Offset:
SELL (number of contract)
(types of instrument) at
(price)
HINT: Everytime an investor opens
his/her position with BUYING
strategy,he needs to close (offset) his
position with SELLING. or vice versa.
OR
Today (Jan)
Later (March)
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BMDB
SELL (number of contract)
(types of instrument) at
(price)
Offset:
BUY (number of contract)
(types of instrument) at
(price)
The difference between the
selling and buying price will be the
profit (loss) earned by the investor.
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FUTURES AND OPTIONS (FIN379)
Ooopss!! I forgot
to close out my
futures position !!
You don’t have to worry.
MDCH will act on behalf of
your position. (Novation)
• Deep Market
Easy Grading
Free Fluctuation
Active
Participation
Underlying
Instrument
Grade / Quality
Price Quotation
Contract Size
Contract Month
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Basic Requirements for Viable Futures Market
Every futures must have sufficient number of buyers and sellers in
order to provide continuous opportunity for trade, and hence
abundant supply.
The commodity selected for trading has to be easily graded, and
hence standardized grading.
Price must be free to fluctuate without any government control
and monopoly power, and hence create volatility.
Market cannot performed if there are no active participation of
buyer and seller.
Contract Specifications
It must have physical instrument traded in the physical market. This
is because the price of futures market is based on the actual price of
physical instrument (underlying). Example: CPO Futures (FCPO) is
the futures instrument while physical crude palm oil is the underlying
instrument.
The underlying instrument should be specified to ensure that every
participant is trading accordingly
Quoted in RM
Number of units or amount that is covered by futures contract
Example: The size of contract of CPO futures is 25 tons of oil palm.
The month of maturity or expiry. Every futures market must have
the spot or current month and future or forward months.
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FUTURES AND OPTIONS (FIN379)
INTRODUCTION TO FUTURES AND OPTIONS | MALAYSIAN DERIVATIVES
Expiry Date
Example:If it is now August 2017, then August is the spot month and
September and October are the forward months available for trading.
The day of settlement of outstanding contracts at expiry price
Physical Delivery Vs Cash Settlement
It is aimed for financial futures (intangible)
It is aimed for commodity futures
– Cannot be delivered physically and hence,
(tangible). The buyer of commodity
the contract should be settled by cash upon
futures is required to take delivery of
maturity through the clearing house.
physical commodity
upon payment,
and
the seller to make a delivery for payment
at maturity date.
Commodity futures have
storage value, and hence can be
delivered physically at maturity.
All outstanding contracts in
commodity futures are required
to be settled by physical delivery.
The buyers and sellers are obligated to
fulfill their contracts either by offsetting
(prior to maturity) or settlement (at
maturity).
Long Position
•
A buyer/seller (during contracting
day) will become a seller/buyer
(at maturity date).
Both are required to settle only
the cash price differential (the
difference between opening price
(when the contract was opened)
and the settlement price.
(contract expired)
A trader who makes profit will receives a
cash differential from his broker, and a
trader who loses will pay a cash
differential to his broker.
A LOSS to a BUYER is a PROFIT to a SELLER
Trading Practicalities
This position refers to participant who has BOUGHT a future
contract.
Buying futures contract today at a low price and anticipate
to sell it at higher price prior or at maturity. (Buy Low,Sell
High)
Short Position
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This refers to participant who has SOLD a futures contract because
he expect that the price will fall in the future.
Selling today at higher price and expects to buy back later at a
lower price.
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FUTURES AND OPTIONS (FIN379)
Margin Requirements
It is a legal requirement for buyer and seller to pay a portion (margin) of contract value (5% 10%). Margin can be divided into:
The obligation of buyer and seller to pay a portion (%) in
order to initiate his trading. If his contract worth RM100,000,
Initial Margin
then the margin is RM10,000 (10%). This margin will be
returned when he close-out his contract.
Minimum amount to be maintained and normally below the
• Maintenance Margin
value of initial margin.
It Indicates the initial margin vary according to the closing
• Variable Margin
prices.
• Call Margin
If the margin fallen below the maintenance margin, a broker
will call the investor to top up such shortage.
Types of Spread
A spread is defined as the sale of one or more futures contracts and the purchase of one or
more offsetting futures contracts. A spread tracks the difference between the price of whatever
it is you are long and whatever it is you are short.
Spreading activity of the same delivery month, same market but
DIFFERENT TYPES OF COMMODITY.
Inter – Commodity Spread
Buy June FCPO at BMDB and Simultaneously sell June Gold
at BMDB.
Spreading activity of the same types of commodity, same
Inter – Month Spread
market but DIFFERENT DELIVERY MONTH.
Buy June FCPO at BMDB and simultaneously sell Sept FCPO
at BMDB.
Spreading activity of the same types of commodity, same
Inter – Market Spread
delivery month but in the DIFFERENT MARKET.
Buy June FCPO at BMDB and simultaneously sell June CPO at
Chicago Mercantile Exchange (CME).
Intra – Commodity Spread
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Also known as calendar spread or same as inter – month spread.
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FUTURES AND OPTIONS (FIN379)
•
Basis
•
Convergence
•
Volume
•
Open Interest
•
Contango
•
Backwardation
Other Terms
Is the difference between futures price (contract) and cash
price (spot price) of the underlying instrument (physical).
(Basis = Future Price – Cash Price)
A negative basis means futures price is being trading at
DISCOUNT and a positive is refers to trading at PREMIUM
Normally, the cash and futures price moves in the same
direction
though by not with the same amount.
But if the futures price equals to cash price at maturity, it is
call ‘price convergence’.
It is referred to the number of contracts traded for a given
contract month
It refers to the number of outstanding contracts for a given
contract month (or yet to be closed-out or expire)
This is happened when futures price is higher than spot price
and also when the distant futures contracts have higher prices
than nearby contracts.
Opposite of contango. It occurs when futures price is lower
than spot price and distant contracts have lower prices than
nearby.
The Mechanics of Trading
Hedging
Speculating
Spreading
Arbitraging
All will be discussed in details in the next chapters.
HINT: Terms which are normally
asked in examination.
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FUTURES AND OPTIONS (FIN379)
SELF-ASSESSMENT TASKS
1) What is futures market?
2) Differentiate the followings:
Cash Settlement
Physical Settlement
3) What is meant by investor goes “long” and goes “short” in the investment?
4) Explain on the following terms:
a) Maintenance margin
b) Basis
c) Contango
d) Backwardation
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FUTURES AND OPTIONS (FIN379)
PAST EXAM QUESTIONS
1. Distinguish the following:
i. Commodity futures and financial futures. (5 marks)
ii. Long position and short position. (5 marks)
Dec 2019
2. (a) Identify five (5) basic requirements for a viable futures market. (5 marks) May 2017
3. Explain two (2) main difference between commodity and financial derivatives (5 marks)
Mar 2017
4. Distinguish between inter-market spread and inter-month spread. (5 marks) Oct 2016
5. Explain the following terms in derivative market (5 marks)
I.
II.
Offsetting
Settlement
6. Define the following terms: (10 marks)
I.
Basis
II.
Open Interest
III.
Convergence
IV. Contango
V.
Backwardation
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May 2015
Mar 15
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FUTURES AND OPTIONS (FIN379)
3.0 COMMODITY FUTURES
3.1
Crude Palm Oil Futures (FCPO)
Commodity can be generally defined as anything that the land can produce or be traded on
the land either physical (livestock-based, mineral-based or agricultural-based).
CPO futures is the only successful commodity traded at BMDB. All trading takes place on the
trading floor of the BMDB using an automated-trading exchange.
A commodity futures contract is an agreement to buy or
sell a predetermined amount of a commodity
at a specific
price on a specific date in the future.
Underlying Instrument
Contract Size
Minimum Price
Fluctuation
Contract Months
Trading Hours
Daily Price Limits
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Contract Specification of FCPO
Crude Palm Oil (CPO)
25 metric tons (MT)
RM1 per metric tons
Spot month and the next 5 succeeding months, and thereafter,
alternate months up to 24 months ahead
First session : 10.30am – 12.30pm
Second session : 3.00pm – 6.00pm
With the exception trades in the spot month, trades for future
delivery of CPO in any month shall not be made, during any one
Business Day, at prices varying more than 10% above or below
settlement prices of the Preceding Business Day (“the 10%
Limit”) except as provided below.
When at least 3 non-spot months contracts are trading at the
10% limit, the Exchange shall announce a 10-minute cooling-off
period for all contract months (except the spot month) shall not
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FUTURES AND OPTIONS (FIN379)
vary more than 15% above or below the settlement prices of the
preceding Business day (“the 15% Limit”)
If the 10% Limit is triggered less than 30 minutes before the end
of the first trading session,the following shall apply:
a. The contract month shall not be specified as interrupted
b. The 10% limit shall be applied to all contract months(except
the spot month) for the rest of first trading session.
c. The 15% Limit is limit shall be applied to all contract
months(except the spot month) during the second trading
session.
If the 10% Limit is triggered less than 30 minutes before the end
of second trading session, the 10% Limit shall be applied to all
contract months (except spot month) for the rest of the Business
Day.
Speculative Positions Limit 800 contracts net long or net short for the spot month
10,000 contracts for any one contract month except spot month
15,000 contracts for all contract months combined
Final Trading Day and
Contract expires at noon on the 15th day of the delivery month,
Maturity Date
or if the 15th is non-market day, the preceding Business Day
Tender Period
1st Business day to the 20th Business Day of the delivery month,
or if the 20th is a non-market day, the preceding Business Day
Deliverable Unit
25 metric tons plus or minus not more than 20%
Initial Margin (current)
RM6,000 per contract
Maintenance Margin
RM5,000 per contract
(current)
HINT: Please take note on the
bold parts……..
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FUTURES AND OPTIONS (FIN379)
3.2
Hedging with FCPO
Objective
Advantages
The main concern of hedger (buyer or seller) is to protect their risk
exposure in the cash market.
By hedging, both parties do not have to worry about the rising (concern
for a buyer) or falling (concern for a seller) of palm oil prices.
Once a hedge position is established, hedger will use a profit in the
futures market to cover his expected loss in the cash market. (rising
of cost or falling of revenue).
Futures profit is able to raise the revenue from selling or reduce a
cost of buying palm oil in cash market.
I.
Ultimately, by hedging, hedger has an opportunity to achieve his
price objective as measured by the EFFECTIVE PRICE of palm oil per
ton.
SHORT HEDGE (Selling)
Selling or short hedge will be undertaken if hedger expects that PRICE TO FALL in the future.
In this case producer/hedger will SELL FUTURES TODAY at a higher price and expects to
BUY BACK LATER at lower price.
SOLVED PROBLEM
As a sales manager, you expect price of palm oil are to fall steadily between August (today) and
October 2017 (later). Your projection is to produce 2,500 MT of CPO by October 2017. The
current cash market price is RM2,600 while October futures is quoting at RM2,560 in BMDB . In
response to this you decided to hedge fully by using FCPO. Assuming as expected, in early
October 2017, palm oil prices dropped to RM2,500 and RM2,480 in the cash and futures market
respectively. Show your hedging benefits as measured by effective price.
Solutions
•
Price will fall – short hedge
•
Strategy : Sell today FCPO and buy back later FCPO.
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FUTURES AND OPTIONS (FIN379)
Table 1: Illustration of a Selling (Short Hedge) in the form of table
Today (August)
Later (October)
BMSB ( Cash Market)
Project to produce 2,500
MT of CPO in Oct. 2016.
Current price is RM2,600.
(Expect price to fall: sell )
BMDB (Futures Market)
Opening Contract:
Sell *100 Oct FCPO
at RM2,560
Produced 2,500 MT CPO and
Offsetting Contract:
sold at expected lower price of
RM2,500
Buy *100 Oct FCPO
at RM2,480
Step 1: Determine the number of contracts traded
The number of contracts
= Amount to hedge
Size of contract
= 2,500 tons / 25 tons
= 100 lots
Size of contract for FCPO
is always 25 metric tons
Step 2: Determine the effective price
I.
Futures Position (BMDB)
Futures profit
= (selling – buying) x no. of contracts x contract size
= (RM2,560 – RM2,480) x 100 x 25
= RM200,000
II.
Cash Position (BMSB)
Cash Revenue (short) = Selling Price x no. of tons
= RM2,500 x 2500 MT
= RM6,250,000
(Less than what he could get if he sells in August at RM2,600, i.e RM6,500,000) or (suffered an
expected loss in revenue of RM250,000 ).
FYI, this what is meant by the risk faced by the
seller in the cash market.
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Risk of falling in revenue
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FUTURES AND OPTIONS (FIN379)
III.
Net effect
Net Effect
= Futures profit + Revenue in Cash Market (inflows out of selling)
= RM200,000 + RM6,250,000
= RM6,950,000
IV.
Effective Price
= Net Effect
No. of tons
= RM6,950,000
2,500 MT
= RM2,580
Impact of hedging
Effectively, by hedging a producer managed to sell 2,500 MT of CPO at RM2,580, instead of
RM2,500 without hedging.
Since the market favors (as expected price will fall) the producer of CPO, he managed to
protect his risk exposure in the cash market.
WHAT HAPPENS IF THE PRICE RISES UNEXPECTEDLY INSTEAD OF FALLING? (Market does not
favor the investor)
SOLVED PROBLEM
Referring to the same case, unexpectedly in October 2017, the price risen to RM2,620 in the
cash market and RM2,610 in futures market.
Solution:
•
Price will fall – short hedge (original strategy based on initial expectation)
•
Strategy : Sell today FCPO and buy back later FCPO.
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FUTURES AND OPTIONS (FIN379)
Table 2: Illustration of a Selling (Short Hedge) in the form of table
Today (August)
Later (October)
BMSB ( Cash Market)
Project to produce 2,500
MT of CPO in Oct. 2016.
Current price is RM2,600.
(Expect price to fall: sell )
BMDB (Futures Market)
Opening Contract:
Sell *100 Oct FCPO
at RM2,560
Produced 2,500 MT of CPO and Offsetting Contract:
sold at unexpected higher price
of RM2,620
Buy *100 Oct FCPO
at RM2,610
Step 1: Determine the number of contracts traded (as shown previously)
Step 2 : Determine the effective price
I.
Futures Position (BMDB)
Futures Loss
= (selling – buying) x no. of con x the size of con
= (RM2,560 – RM2,610) x 100 x 25
= (RM125,000)
II.
Cash Position (BMSB)
Cash Revenue
= Selling Price x the no. tons
= RM2,620 x 2500 MT
= RM6,550,000 (he sells at higher price)
III.
Net Effect
Net Effect
= Futures loss + Revenue in Cash Market
= (RM125,000) + RM6,550,000
= RM6,425 ,000
IV.
Effective Price
= Net Effect
No. of tons
=
RM6,425,000
2,500 MT
= RM2,500
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FUTURES AND OPTIONS (FIN379)
Impact of hedging,,
In the event of unexpected rising price, by hedging, a producer manage to sell only at
RM2,500 (in the futures market) compared to without hedging.
However, a loss in futures market (-RM125,000) at least will be covered by a gain in cash
market (+RM50,000 i.e RM2,620 x 2,500 tons – RM2,600 x 2,500 tons). He did not expect
that he could sell at RM2,620 in the cash market.
II.
Long Hedge (Buying)
A buying (long) hedge will be undertaken if a hedger expects that PRICE WILL INCREASE in
the future.
Thus, he intends to BUY CPO FUTURES NOW at a lower price and SELL IT AT A HIGHER
PRICE IN THE FUTURE.
SOLVED PROBLEM
You need 5,000 MT of CPO in December 2018 and strongly believed that the price will increase
between today (August) to mid December. In the cash market, palm oil prices are trading at
RM2,700 per MT while December futures at RM2,730 per MT. As expected, in mid December
the prices are closed at RM2,785 and RM2,796 in the cash and futures market respectively.
Show your hedging benefit as measured by an effective price.
Solution:
•
Price will increase – long hedge
•
Strategy : buy today FCPO and sell back later FCPO.
FO_by_IM
Page 25
FUTURES AND OPTIONS (FIN379)
Table 3: Illustration of a buying (Long Hedge) in the form of table
Today (August)
Later (December)
BMSB ( Cash Market)
BMDB (Futures Market)
Project to have 5,000 MT of
Opening Contract:
CPO in Dec 2017. Current price
is RM2,700.
Buy*200 Oct FCPO
(Expect price to increase: buy ) at RM2,730
Buy 5,000 tons of palm at
higher price of RM2,785
Offsetting Contract:
Sell*200 Oct FCPO
at RM2,796
Step 1: Determine the number of contracts traded (as shown previously).
Step 2 : Determine the effective price.
I.
Futures Position (BMDB)
Futures profit
= (selling – buying) x no. of contracts x contract size
= (RM2,796 – RM2,730) x 200 x 25
= RM330,000
II.
Cash Position (BMSB)
Cash Expenses (buy) = Buying Price x no. of tons
= RM2,785 x 5000 MT
= (RM13,925,000)
(More than what he could buy in August at RM2,700, i.e RM13,500,000) or (suffered an
expected increased in cost of RM 425,000 )
FYI, this what is meant by the risk faced by the
buyer in the cash market.
III.
Risk of increasing in cost
Net effect
Net Effect
= Futures profit + Expenses in Cash Market (outflows of buying)
= RM330,000 + (RM13,925,000)
= (RM13,595,000)
FO_by_IM
Page 26
FUTURES AND OPTIONS (FIN379)
IV.
Effective Price
Net Effect
No. of tons
= (RM13,595,000)
5000 MT
=
=
RM2,719
Impact of hedging
Effectively, refiner bought 5,000 tons at RM2,719 even though the market price in
December was RM2,785.
By hedging a future profit of RM330,000 will be used to reduce the cost of buying physical
palm oil, hence, representing a saving to a refiner.
A refiner achieved his price objective because he has the ability to buy at lower price and
minimizing his cost.
3.3
Speculating with FCPO
Objective
Advantage / Strategy
Speculators are motivated with profit even though they do not own
or wish to own any physical oil palm
Normally speculators will BUY FUTURES NOW (LOWER PRICE)when
they expect prices to move upwards and SELL LATER AT HIGHER
PRICE (buy low,sell high)
OR
Sell today at high price and buy back later at lower price (Sell
high,buy low)
Once the speculators made a contract (contract is opened), they
have to pay the margin requirements and commission charges.
His position will be marked daily according to market (closing)
prices. This is called marked-to-market position.
What is Marked-to-market position?
The strategy whereby an investor / speculator has
to mark their position based on daily closing
prices. The floating profit or loss will be calculated
accordingly on daily basis.
FO_by_IM
Page 27
FUTURES AND OPTIONS (FIN379)
I
Speculative Selling
Speculative selling occurred when investor expects the price of the CPO futures will FALL in the
near future.
SOLVED PROBLEM
Mr. Ejaz believes that the price of palm oil will fall in the short future. He asked his broker to
sell 8 contracts of CPO futures at RM2,685 per ton. Assuming that he has to pay an initial
margin of RM8,500 and maintain RM7,500 per contract, prepare the marked-to-market
position on the basis of the following closing prices for 5 days of trading.
Day
1
RM2,681
2
RM2,674
3
RM2,678
4
RM2,686
5
RM2,699
Solutions
•
Price will fall – short speculating / speculative selling
•
Strategy – Opening position : Sell (today or day 0)
Table 4: Illustration of the question using table (speculative selling)
Day
0
1
2
3
4
5
FO_by_IM
Closing Price
RM2,685 (futures price today)
RM2,681
RM2,674
RM2,678
RM2,686
RM2,699
Floating Profit/Loss
+RM 800
+RM1,400
-RM 800
-RM1,600
-RM2,600
Total profit/loss
Current Margin
*RM68,000
RM68,800
RM70,200
RM69,400
RM67,800
RM65,200
(RM 2,800)
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FUTURES AND OPTIONS (FIN379)
Step 1 : Determine the initial margin and maintenance margin
Initial Margin
= RM8,500 x 8 contracts
= RM68,000* ( this would be the current margin for Day 0)
Maintenance margin = RM 7,500 x 8 contracts
= RM60,000
(speculator must maintain minimum amount or RM60,000 in his current margin)
Step 2: Determine the total floating profit / loss
There are three (3) ways in calculating the total floating profit / loss and all these three ways
will provide with the same answer.
a)
From the current margin, ending margin (Day 5) minus the beginning (Day 0)
= RM65,200 – RM68,000
= (RM2,800) – Loss
b)
Until Day 5, floatation profit (loss) is 800 + 1,400 + (800) + (1,600) + (2,600) = (RM2,800)
c)
OR (selling – buying) x 8 x 25
= (RM2,685 – RM2,699) x 8 x 25
= (RM2,800)
Why arrow down
FO_by_IM
???
To show that speculator starts the strategy
with selling whereby selling
price will always
be deducted to buying
price.
(selling – buying)
Page 29
FUTURES AND OPTIONS (FIN379)
As for daily floating profit or loss, here are the details of calculations:
•
Day 1 - Profit (Loss) = (RM2,685 – 2,681) x 8 x 25 = RM800
•
Day 2 - Profit (Loss) = (RM2,681 – 2,674) x 8 x 25 = RM1,400
•
Day 3 - Profit (Loss) = (RM2,674 – 2,678) x 8 x 25 = (RM800)
•
Day 4 - Profit (Loss) = (RM2,678 – 2,686) x 8 x 25 = (RM1,600)
•
Day 5 - Profit (Loss) = (RM2,686 – 2,699) x 8 x 25 = (RM2,600)
II
Speculative Buying
Speculative buying occurred when investor expects the price of the CPO futures will INCREASE
in the near future.
SOLVED PROBLEM
Now, by using the same information from speculative selling above, let’s consider that Miss
Warda bought CPO futures contract at RM2,685. (She is taking the opposite position of
Mr.Ejaz
as she has different perception that price will increase in the future.) What will be her profit
out of the transaction?
Solutions:
•Price will increase (based on Miss Warda’s expectation) – Long speculating / speculative buying
•Strategy – Opening position :Buy (today or day 0)
Table 5: Illustration of the question using table (speculative buying)
Day
0
1
2
3
4
5
FO_by_IM
Closing Price
RM2,685 (futures price
today)
RM2,681
RM2,674
RM2,678
RM2,686
RM2,699
Floating Profit/Loss
-
Current Margin
*RM68,000
-RM 800
-RM1,400
+RM 800
+RM1,600
+RM2,600
Total profit/loss
RM67,200
RM65,800
RM66,600
RM68,300
RM70,800
RM 2,800
Page 30
FUTURES AND OPTIONS (FIN379)
Step 1 : Determine the initial margin and maintenance margin
Initial Margin
= RM8,500 x 8 contracts
= RM68,000* ( this would be the current
margin day 0)
Maintenance margin = RM 7,500 x 8 contracts
= RM60,000
(speculator must maintain minimum amount or RM60,000 in her current margin)
Step 2: Determine the total floating profit / loss
a)
From the current margin, ending margin (Day 5) minus the beginning (Day 0)
= RM70,800 – RM68,000
= RM2,800 (Profit)
b)
OR Until Day 5, floatation profit (loss) is (800) + (1,400) + 800 + 1,600 + 2,600 = RM2,800
c)
OR (selling – buying) x 8 x 25
= (RM2,699 – RM2,689) x 8 x 25
= RM2,800
While Mr Ejaz suffered with a loss amounting of (RM2,800) , Miss Warda enjoyed the
profit with the same amount of RM2,800. A profit to a seller is a loss to a buyer or a loss
to a seller is a profit to a buyer (zero-sum game).
Why arrow up
FO_by_IM
???
To show that speculator starts the strategy with
buying whereby buying price
will always be
deducted from selling
price.
(selling – buying)
Page 31
FUTURES AND OPTIONS (FIN379)
As for daily floating profit or loss, here are the details of calculations :
III
•
Day 1 - Profit (Loss) = (RM2,681 – 2,685) x 8 x 25 = (RM800)
•
Day 2 - Profit (Loss) = (RM2,674 – 2,681) x 8 x 25 = (RM1,400)
•
Day 3 - Profit (Loss) = (RM2,678 – 2,674) x 8 x 25 = RM800
•
Day 4 - Profit (Loss) = (RM2,686 – 2,678) x 8 x 25 = RM1,600
•
Day 5 - Profit (Loss) = (RM2,699 – 2,686) x 8 x 25 = RM2,600
SPECULATIVE SELLING WITH MARGIN CALL
SOLVED PROBLEM
Miss Inara believes that the price of palm oil will fall in the short future. She asked her broker to
sell 8 contracts of FCPO at RM2,683 per ton. Assuming that she has to pay an initial margin
RM65,000 and maintain RM63,000, prepare the marked-to-market position on the basis of the
following closing prices for 5 days of trading.
Day
1
RM2,681
2
RM2,685
3
RM2,690
4
RM2,695
5
RM2,692
Solutions
•
Price will fall – short speculating / speculative selling
•
Strategy – Opening position : Sell (today or day 0)
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
Table 6: Illustration of the question using table (speculative selling)
Day
0
Closing Price
RM2,683 (futures price
today)
RM2,681
RM2,685
RM2,690
RM2,695
Call Margin
RM2,692
1
2
3
4
5
Floating Profit/Loss
-
Current Margin
*RM65,000
+RM 400
-RM 800
-RM 1,000
-RM 1,000
RM 2,400*
+RM 600
Total profit/loss
RM65,400
RM64,600
RM63,600
RM62,600
RM65,000
RM65,600
(RM1,800)
Oppppsss!!! On day 4, the margin has fallen below the
maintenance margin. What should the spreader do?
Call Margin has to be incurred amounted of
RM2,400 (RM65,000 – RM62,600) as we
have to
top up the amount up to Initial Margin.
Step 1: Determine the Initial margin and maintenance margin (given)
Step 2: Determine the total floating profit/loss
Floating profit/loss
You may use either one of the three (3) ways explained previously.
a)
Ending margin (Day 5) minus the beginning (Day 0) minus the call margin (extra
money put in)
= RM65,600 – RM65,000 – RM2,400
= (RM1,800) – Loss
b)
OR, Until Day 5, floatation profit (loss) is 400 + (800) + (1,000) + (1,000) + 600
= (RM1,800)
c)
OR (selling – buying) x 8 x 25
= (2,683 – 2,692) x 8 x 25
= (RM1,800)
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
3.4
Spreading with FCPO
Objective
Spreading by the means is taking of two opposite positions in
order to spread the price risk between two contract months
simultaneously.
Spreader will focus on narrowing ( - ) or widening ( + ) of spread
between today (opening contract) and later (offsetting
contracts)
Advantage /Strategy
A contract month which is quoting at HIGHER PRICE
WILL BE SOLD and LOWER PRICE WILL BE BOUGHT.
SOLVED PROBLEM
Today (early Aug.), Mr. Rafi observes that October FCPO are trading at RM2,680, while
November FCPO at RM2,595. Assume that in early October Mr Rafi decided to close-out both
contracts when October and November FCPO are trading at RM2,605 and RM2,588
respectively. How much is the spreading profit.
Solutions
Today ( August)
Oct futures
: RM2,680
Nov futures
: RM2,595
*refer price today. Oct futures is quoted higher than
Nov futures.
Later (October)
Strategy: Sell Oct futures, Buy Nov futures today.
Oct futures
: RM2,605
Nov futures
: RM2,588
Table 7: Illustration of the question using table (spreading)
Today (Aug)
Later (Oct)
Spread (bp)
FO_by_IM
Oct Futures
Sell 1 Oct FCPO at
RM2,680
Buy 1 Oct FCPO at
RM2,605
+75 bp
(2,680 – 2,605)
Nov Futures
Buy 1 Nov FCPO at
RM2,595
Sell 1 Nov FCPO at
RM2,588
-7bp
(2,588 – 2,595)
Spread (bp)
+85 bp
(2,680-2,595)
-17 bp
(2,588-2,605)
+68bp
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FUTURES AND OPTIONS (FIN379)
Determination of spreading profit/loss
Spread profit
= 68 x 1 contract x RM25
= RM1,700 (excluding commission)
Hmmmm…What will happen to
the profit if the spreader has to
pay commission?
Assume that the spreader has to pay commission of RM100 per round contract, how much
is the profit/loss?
How to determine the round of contract or the number of contract?
Oct futures = 1 contract (sell and then offsetting by buying 1 contract = 1 round)
Nov futures = 1 contract (buy and then offsetting by selling 1 contract = 1 round)
So,total spreader has only 2 number of contracts.
Net Profit
It shouldn’t be 4 contracts.
= RM1,700 – 2 (RM100)
= RM1,500
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
3.5
Arbitraging with FCPO
Objective
Advantage /Strategy
Arbitraging by the means is taking two opposite positions in
two different markets (one in cash, the other is futures,
simultaneously)
Arbitrageur will BUY the instruments when they determined
that the futures price is UNDER-PRICED or they will SELL it if
the futures price is OVER-PRICED.
SOLVED PROBLEM
As a professional arbitrageur, you observe that at the end of August, the spot price for CPO is
RM2,675 while in September futures is trading at RM2,765. Assume that cost of storage is RM12 per
month per MT and risk free rate is 5.5%. Show the arbitrage profit, if any for 250 tons of CPO.
Solutions
Step 1: Determine the fair value (true price) – using Cost-of-Carry Model:
F = (S (1 + (R x T/365) ) + (C x T/365)
F = Futures (forward) Price
S = Cash (spot) Price
R = Risk-free Interest Rate
C = Cost of Storage (RM per ton per year)
T = Days to Maturity
Step 2: Compare to Actual Price – the price that is currently trading in the futures market.
Whenever the actual price (current futures price) is ABOVE the true price :
OVER-PRICED – a SELL is recommended (i.e sell today and buy back later)
Means an arbitrageur should sell futures and buy physical.
Whenever the actual price (current futures price) is UNDER the true price
UNDER-PRICED – a BUY is recommended (i.e buy today and sell back later)
Means an arbitrageur should buy futures and sell physical.
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
Step 3 : Illustrate the strategy taken in the form of table
Step 4 : Determine the arbitrage profit / loss
RM12 x 12
Solutions
months
Step 1: Calculate the (Fair - calculated) True Price
F = 2,675 {1 + (0.055 x 30/365) + (144 x 30/365)}
F = 2,675 (1.004) + (11.836)
th
End of Aug till 15 Sept
= RM2,698
*Since the expiry date for FCPO is
th
on 15 day of delivery month.
Step 2: Compare to Actual Price (current Futures price)
RM2,698 vs RM2,765 (over-priced)
On the basis of fair value model, September CPO futures should be traded at RM2,698
(true price) and not at RM2,765 (actual price) – September CPO futures is over-priced.
Therefore SELL Sept CPO futures and BUY physical (cash market)
Step 3: Illustrate the strategy taken in the form of table
Table 7: Illustration of the strategy using table (arbitraging)
Cash Market (BMSB)
Today (August)
Later
(September)
Futures Market (BMDB)
Buy 250 MT of CPO at RM2,675. Sell 10 Sept FCPO at RM2,765
Hold 250 MT of CPO
to be Arrange for delivery of 250 MT of
delivered at designated port.
CPO through MDCH for cash.
Step 4: Determine the arbitrage profit / loss
I.Revenue from selling
250 MT of Sept FCPO x RM2,765
= + RM691,250
II.Expenditure for buying
250 MT of Physical CPO x RM2,675
= (RM668,750)
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FO_by_IM
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FUTURES AND OPTIONS (FIN379)
III.Interest expenses for borrowing
RM668,750 x 5.5 % (1/12)
= (RM3,065)
IV.Cost of storage
250 MT x RM 12 per ton per month
= (RM3,000)
_________
GROSS PROFIT
FO_by_IM
= RM16,435
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FUTURES AND OPTIONS (FIN379)
SELF-ASSESSMENT TASKS
1) What is marked-to-market position?
2) Miss Mia is an active investor in BMDB. She wants to short six (6) June FCPO at RM2,000
per ton. She needs to pay an initial margin of RM6,250 per contract and need to
maintain 80% of the total initial margin.
Prepare her marked-to-market position based on the following information:
Day
1
2
3
4
Closing Price (RM)
2,870
2,780
2,900
2,960
3) As an arbitrageur, you observed that at the beginning of April, the spot price of CPO is
RM2,140 while June FCPO is trading at RM2,200. The monthly cost of carry is RM12 per ton
and the rsik free rate is 6.25% per annum. You strongly believe opportunity can be created
for 600 ton of CPO.
Establish the arbitrage activity and show your profit, if any.
4) Suppose you are the purchasing officer and just signed a contract to buy for 580 MT of CPO
for delivery in September,2016. You expect price to increase in near future. You have
decided to hedge your exposure in BMDB. The current prices of FCPO are as follows:
Contract
June 2016
July 2016
August 2016
September 2016
Month
Price (RM)
2,268
2,277
2,275
2,272
a) Would you buy or sell futures?
b) How many contracts will you execute?
c) Which contract month would you see and what price would your hedge be executed?
Additional information:
th
On September 5 , you close-out your hedge at RM2,275 per MT and spot price of CPO is
RM2,270 per MT. Determine:
a) The effective price of the hedging transaction. Comment on that.
39 | P a g e
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
PAST EXAM QUESTIONS
1. A palm oil producer company in Johor is negotiated a sale of 2,000 tons of CPO to a buyer
on 1st Dec 2019. The buyer agreed and the transaction will take place in Feb next year.The
company notes that the spot price on 1st Dec 2019 is RM2,150 and believes that the price
will go down for the next few months. In response to this, the company decided to hedge
fully by using the futures contract. Today, the futures price is quoted at RM2,154. Later in
February, the futures price and spot price drop by RM24 in each market respectively.
Feb 2020
i.
ii.
iii.
Establish the appropriate trading activities for the above. (7 marks)
Show the net effect of the strategy taken in RM. (6 marks)
Compute the effective price for the above trading. (2 marks)
2. You have gone long ten (10) contracts of October FCPO at the futures price of RM2,200 per
ton. If the initial margin is 10 percent of the total contract value and the maintenance
margin is 60 percent of the initial margin, prepare the daily marked-to-market position
based on the following daily closing prices.
Dec 2019
Day
1
2
3
4
5
Settlement Price (RM)
2,810
2,780
2,770
2,800
2,820
(15 marks)
3. In September, a trader noted that the November CPO futures (FCPO) is trading at RM2,175
while the December FCPO is trading at RM2,170. The trader believes the spread between
the two contract months will narrow over the next month, while the November prices
falling more sharply than the December.
.
Mar 2017
i.
ii.
Determine which contract month the trader should sell and buy in September?
(2 marks)
Calculate the profit or loss if the trader needs 1,000 MT of FCPO
(3 marks)
b) A trader buys one FCPO contract at RM2,095 and the price rises to RM2,120. The market
then falls and the trader liquidates at RM2,105. Indicate whether the trader makes a profit
or loss on this transaction.
(5 marks)
c) State five (5) factors that would be likely to affect the price of CPO and FCPO. (5 marks)
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
4. Company YY has a requirement of 100,000 MT of CPO as raw materials in December 2015.
Today, October 2015, the company managed to buy 20% of CPO fort the first stage and
30% for the second stage in the cash market at a price of RM2,600 per ton. In anticipation
of rising prices, the company decides to hedge the remaining requirement. At present, CPO
prices are trading at RM2,620 per MT while November , December 2015, January 2016,
FCPO are trading at RM2,670 , RM2,660, and RM2,690 respectively. At maturity, futures
prices close at RM2,620 and RM2,630 for December 2015 and January 2016 respectively
and cash prices at RM2,610.
Oct 2016
I.
II.
III.
Establish an appropriate strategy for the above (7 marks)
Show quantitatively the hedging benefit as measured by effective price. (6 marks)
Interpret the results based on the answer in (II). (2 marks)
5. Based on the market volatility and adverse price movement between today , January to
mid March 2014, the purchasing department of food manufacturer placed an order of
5,000 MT of CPO, which to be delivered to the factory in March 2014. Following data is
available for FCPO trading. Mar 2014
January 2014
CPO price
March FCPO
: RM2,550 per MT
: RM2,580 per MT
March 2014
CPO price
March FCPO
: RM2,560 per MT
: RM2,600 per MT
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
4.0 EQUITY FUTURES
4.1
Kuala Lumpur Composite Index Futures (FKLI)
Index futures are related to equity futures because `index measures the overall performance of a
given stock market’
Kuala Lumpur Composite Index (KLCI) has become the official index for Bursa Malaysia
Since the KLCI
futures is the derivatives instrument and KLCI is the underlying instrument,
therefore:
KLCI Futures (FKLI)
KLCI
- futures index
- cash index.
KLCI Futures Contract (FKLI) is an agreement between buyer
and seller to make and take delivery of the basket of shares
(do not involve physical delivery) at an agreed price, at a
specified future date (settlement only can be done by cash).
Underlying Instrument
Contract Size
Tick size (Minimum
Fluctuation)
Contract Months
Trading Hours
Daily Price Limit
FO_by_IM
Contract Specification of FKLI
FBM KLCI futures (FKLI)
Index multiplied with RM50
0.5 index valued at RM25
Spot month and the next month, and the next 2 calendar
quarterly months.
Quarter months :March, June, September,and December
First session : 8.45 am – 12.45 pm
Second session : 2.30 pm – 5.15 pm
20% per trading session for the respective Contract Months
except the spot month contract. There sall be no price limit for
Page 42
FUTURES AND OPTIONS (FIN379)
the spot month contracts. There will be no price limit for the
second month contract for the final 5 business days before
expiration.
Speculative Positions Limit 10,000 FKLI-equivalent contracts net gross open position
Final Trading Day and
The last Business Day of the contract month
Maturity Date
Settlement Type
Cash Settlement based on the Final Settlement value
HINT: Please take note on
the bold parts.
4.2
Hedging with FKLI
To hedge with KLCI futures, hedger must determine the number of contracts to be bought or
sold by considering 2 economic variables;
% of hedge – hedge fully (100%) or just a portion
Beta of portfolio – the volatility of portfolio relative to the market. A beta of 1.00 is equivalent
to the market. When a portfolio beta does not equal to the market (more or less than),the
number of contracts to be traded will be less or more
If % to hedge or beta is not mentioned, just assume 100% and 1 respectively.
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
By considering the two variables, the number of contracts to be bought or sold can be
determined by using the formula:
Number of Contracts = Amount to hedge x % of hedging x Beta
Value of Contract
Where;
Amount to hedge : the value of portfolio to be bought/sold or currently held
Value of contract : opening price of futures contract x RM50
I. Long Hedge
Long hedge strategy is taken in anticipating of RISING in the price of KLCI.
Investor will BUY FKLI today and will SELL back the FKLI later.
SOLVED PROBLEM
As a corporate planner from unit trust company, you are anticipate to pool RM100 million funds in
November and expect that there will be an increase in the price of KLCI. Today, early September,
cash index (KLCI) stands at 1555 in Bursa Malaysia while November futures index (FKLI) quotes at
1570 in BMDB. Assuming you plan to hedge fully and having a portfolio beta of 0.92, show your
hedging benefits if both prices converged at 1600.
Solutions
•
The price of KLCI increased – Long hedge
•
Strategy – BUY FKLI today at lower price, SELL back FKLI at higher price later
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FUTURES AND OPTIONS (FIN379)
Table 8: Illustration of a buying (Long Hedge) in the form of table
Today
(Early September)
Later
(End November)
BMSB ( Cash Market)
Expect to pool RM100m in
November to be invested in
BMSB. Current index = 1555
Buy)
(Expect index to :
BMDB (Futures Market)
Opening Contract
Buy *1,172 November FKLI at
1570
Pooled RM100m
to buy Offsetting Position
physical shares at higher prices
and current index = 1600
Sell *1,172 November FKLI at
(Rising index as expected)
1600
Step 1: Determine the number of contracts traded
*Number of contracts = (RM100 mil x 100% x 0.92) / (1570 x 50) = 1,172 contracts
Contract size of
FKLI is RM50
Step 2: Determine the effective price
I.
Futures Position (BMDB)
Futures profit
= (selling - buying) x no. of contracts x RM50
= (1600 – 1570) x 1172 x RM50
= + RM1,758,000
II.
Cash Position (BMSB)
Increase in Price
= (Ending Index – Beginning Index) x Fund allocated
Beginning Index
= (1600 – 1555) x RM100,000,000
1,555
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FUTURES AND OPTIONS (FIN379)
= RM 2,893,891 (additional payment)
FYI, this what is meant by the risk faced by the
buyer in the cash market.
III.
Risk of increasing in cost
Net Effect
Net Effect
= Futures profit – increase in cost in Cash Market
= + RM1,758,000 – RM2,893,891
IV.
= - RM1,135,891 (Actual additional cost of buying
shares instead of –RM2,893,891).
Futures profit will be used to cover the rising cost of buying physical shares
Effective Price (Index)
= Total cost of purchasing
No. of contracts X RM50
Without hedging
= RM100,000,000 + RM2,893,891
1172 x RM50
= 1755
With hedging
= RM100,000,000 + RM1,135,891
1,172 x RM50
= 1725
Impact of hedging
Effectively with hedging, a portfolio manager managed to invest only at RM101,135,891
(lower index of 1725) instead of RM102,893,891 without hedging and at higher index of
1755.
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FUTURES AND OPTIONS (FIN379)
II.
Short Hedge
Short hedge strategy is taken in anticipating of FALLING in the price of KLCI.
Investor will SELL FKLI today and will BUY back the FKLI later.
SOLVED PROBLEM
As an investment, you anticipate Bursa Malaysia is to experience another downtrend between
today (August) and near future (November). Currently, cash index (KLCI) is trading at 1600 while
November futures index (FKLI) quotes at 1510 in BMDB. You are managing a portfolio worth 50
million and decided to hedge 80% of that portfolio with beta 1.15. As expected, at the end of
November cash index closed at 1480 while futures index at 1430. Establish you hedging
strategy by showing your hedging benefits.
Solutions
The price of KLCI will decrease – Short hedge
Strategy – SELL FKLI today at lower price, BUY back FKLI at higher price later
Table 9: Illustration of Establishment of a selling (Short Hedge) in the form of table
Today
(August)
Later
(End November)
BMSB ( Cash Market)
BMDB (Futures Market)
Managing
RM50
million Opening Position
portfolio and to hedge RM40
million.
Sell *609 November FKLI at
(Expect price : sell)
1510
Current index = 1600
Sell RM40 million of portfolio
at lower price (Falling index to
1480)
Offsetting Position
Buy *609 November FKLI at
1430
Step 1: Determine the number of contracts traded
*Number of contracts = (RM50 mil x 80% x 1.15) / (1510 x 50) = 609 contracts
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FUTURES AND OPTIONS (FIN379)
Step 2: Determine the effective price
I.
Futures Position (BMDB)
Futures profit
= (selling - buying) x no. of contracts x RM50
= (1510 – 1430) x 609 x RM50
= + RM2,436,000
II.
Cash Position (BMSB)
Decrease in Price
= (Ending Index – Beginning Index) x Fund allocated
Beginning Index
= (1480 – 1600) x RM50,000,000
1600
= - RM3,750,000 (less in revenue)
FYI, this what is meant by the risk faced by
the seller in the cash market.
III.
Risk of falling in revenue
Net Effect
Net Effect
= Futures profit - Loss in Cash Market
= + RM2,436,000 – RM3,750,000
= -RM1,314,000 (Actual loss of revenue from selling
shares instead of – RM3,750,000)
Futures profit will be used to cover the falling revenue from selling shares.
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FUTURES AND OPTIONS (FIN379)
IV.
Effective Price (Index)
=
Without hedging
=
With hedging
=
Total proceed of selling
No. of contracts X RM50
RM50,000,000 + (RM3,750,000)
609 x RM50
= 1518
RM50,000,000 + (RM1,314,000)
609 x RM50
= 1598
Impact of hedging
With hedging, a manager can reduce the loss from RM3,750,000(without hedging) to
only RM1,314,000 and manage to sell at higher price which is 1598 compared to 1518.
III. Portfolio Hedge (holding Hedge for indefinite period)
This is happened when the investor has no intention to sell physical shares.
SOLVED PROBLEM
As an investment manager, you are managing a portfolio worth RM250 millions. You believed
that the Malaysia share prices will keep on dropping between today (early September to end
of the year (late December). Currently, you observe that cash index is quoting at 1500 in the
BMSB while December futures (FKLI) at 1400 in the BMDB. If cash index traded at 1380 and
futures index at 1320 in mid December, show your hedging benefits if the manager still keeps
the shares and has no intention to sell. Assume that beta is 1.00
Solutions
FO_by_IM
The price of KLCI will decrease – Short hedge
Strategy – SELL FKLI today at lower price, BUY back FKLI at higher price later.
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FUTURES AND OPTIONS (FIN379)
Table 10: Illustration of a selling (Short Hedge) in the form of table
Today
(Early September)
BMSB ( Cash Market)
Managing RM250 million
portfolio.
(Expect price : Sell)
Current index = 1500
BMDB (Futures Market)
Opening Position
Sell *3,571 September FKLI at
1400
Offsetting Position
Later
(Mid December)
Still hold RM250 million with
less value
(Falling index to 1,380)
Buy *3,571 September FKLI at
1320
Step 1: Determine the number of contracts traded
*Number of contracts = (RM250 mil x 100% x 1.0) / (1400 x 50) = 3,571 contracts
Step 2: Determine the effective price
I.
Futures Position (BMDB)
Futures profit (realized)
= (selling - buying) x no. of contracts x RM50
= (1400 – 1320) x 3571 x RM50
= + RM14,284,000
II.
Cash Position (BMSB)
Decrease in Price
= (Ending Index – Beginning Index) x Fund allocated
Beginning Index
= (1380 – 1500) x RM250,000,000
1,500
= - RM20,000,000 (Loss in value of shares)
III.
Net Effect
Net Effect
= Futures profit - Loss in Cash Market
= + RM14,284,000 - RM 20,000,000
= - RM5,716,000
50 | P a g e
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FUTURES AND OPTIONS (FIN379)
Impact of hedging
Investor will BUY FKLI today and will SELL back the FKLI later.
Even though the expected loss in value (RM20,000,000) in the cash market, but it still be
covered by the futures profit of RM14,284,000.
The actual value dropped NOT to RM230,000,000 (RM250mil – RM20mil)(without
hedging) but only to RM244,284,000 (RM250mil – RM5,716,000) (with hedging).
Reason of holding: If he keeps holding, he may enjoy dividend revenue at the end of
the year.
4.3
Speculating with FKLI
Normally speculators will BUY FUTURES NOW (LOWER PRICE) when they expect prices to move
upwards and SELL LATER AT HIGHER PRICE (buy low sell high).
OR sell today at high price and buy back later at lower price (Sell high buy low)
I.
Speculative Selling
Speculative selling is taken in anticipating of FALLING in the prices of futures index.
SOLVED PROBLEM
As a semi-pro speculator, you believe that share prices at the Bursa Malaysia will keep on falling
in the near future. For this reason, you asked your broker to short ten (10) FKLI contracts at a
price (index) of 1456. Assuming you are required to pay RM75,000 and maintain 80% of it,
prepare your marked-to-market position on the following closing prices (indices):
Day
FO_by_IM
1
1450
2
1442
3
1431
4
1436
5
1440
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FUTURES AND OPTIONS (FIN379)
Solutions
Price will fall – short speculating / speculative selling
Strategy – Opening position : Sell (today or day 0)
Table 11: Illustration of the question using table (speculative selling)
Day
0
1
2
3
4
5
Closing Price
1456 (futures index today)
1450
1442
1431
1436
1440
Floating Profit/Loss
+RM3,000
+RM4,000
+RM 5,500
-RM2,500
-RM2,000
Total profit/loss
Current Margin
RM75,000
RM78,000
RM82,000
RM87,500
RM85,000
RM83,000
RM8,000
Step 1: Determine the initial margin and maintenance margin
Initial Margin
= RM75,000
Maintenance margin
= 80% x RM75,000
= RM60,000
( speculator must maintain minimum amount or RM60,000 in his current margin)
Step 2: Determine the total floating profit or loss
Do you still remember that you may determine the floating profit
/loss using 3 ways, and……either way will give you the same answer.
Profit (The simplest way)
= (selling – buying) x no. of contracts x size of contracts
= (1456 -1440) x 10 x RM50
= RM8,000
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FUTURES AND OPTIONS (FIN379)
Step 3: Determine the price change and rate of return
Price (index) change
= (Selling – buying)
buying
= (1456 – 1440)
1440
= 1.11%
Rate of return
= Total profit (loss)
Current margin day 5 (last day of transaction)
= + RM8,000
83,000
= 9.64%
This indicates that the price change is only 1.11% (small change) but the rate of return is
9.64% (big profit).
4.4
Spreading with FKLI
Spreading is taking of TWO OPPOSITE POSITIONS in order to spread the price risk between two
contract months simultaneously.
A contract month which is quoting at higher price will be sold (bearish prospect) and lower
price will be bought (bullish prospect).
The concept and strategy is same as in the FCPO at the BMDB
In order to test your level of understanding, please attempt
any related question from past exam questions.
HAVE FUN TRYING!!!!
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FUTURES AND OPTIONS (FIN379)
However, in the case of inter – market spread ;
Inter – market spread
: BUY futures today @ OUTPERFORMED market
: SELL futures today @ UNDERPERFOMED market
SOLVED PROBLEM
As an investor, Mr Khuzairi believes that the KLCI market will outperform the S&P in the future.
Currently in September, KLCI stands at 1,400 while the S&P stands at 1,300.
The contract value for S&P is 200 times of its index and the exchange rate is RM3.50 per USD.
As in December, the indices are as followings:
KLCI
: 1670
S&P
: 1419
Establish the strategy taken by Mr Khuzairi and calculate the profit / loss out of the transaction.
Solutions
Step 1: KLCI outperformed – BUY FKLI, SELL S&P
Step 2: Determine the contract value for both indices
KLCI
: 1400 x RM50 = RM70,000
S&P
:1300 x 200
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= USD260,000
= USD260,000 x RM3.50 = RM910,000
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FUTURES AND OPTIONS (FIN379)
Step 3: Determine the number of contracts
S&P
:
KLCI
RM910,000
:
RM70,000
1
:
13
Number of contracts = RM910,000/ RM70,000
= 13
(He needs to buy 13 FKLI contracts in making
it equivalent to 1 S&P contract)
Table 12: Illustration of the strategy in the form of table
FKLI
S&P 500
September
Buy 13 FKLI contract at 1400
Sell 1 S&P contract at 1300
December
Sell 13 FKLI contract at 1670
Buy 1 S&P contract at 1419
Spread (Bp)
270
-119
Calculations
Profit /loss
S&P
= (119) x 1 x 200 x RM3.50
= (RM83,300)
KLCI
= 270 x 13 x RM50
= RM175,500
____________
Profit/loss
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= RM92,200
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FUTURES AND OPTIONS (FIN379)
4.5
Arbitraging with FKLI
Taking TWO OPPOSITE POSITIONS in two different markets (one in cash, the other is futures,
simultaneously)
Arbitrageurs would buy or sell the instruments when they determined that the futures index
is significantly different from the actual index based on the fair value model. In other words,
when there is a price mismatch.
UNDER-PRICED - Buy @ Futures Market, Sell @ Cash Market
OVER-PRICED - Sell @ Futures Market, Buy @ Cash Market
SOLVED PROBLEM
Today (early September), you believe that quotations of KLCI futures are mismatched. Currently,
the spot index is quoting at 1490 while October futures (FKLI) at 1560. Assuming that you plan to
trade 32 contracts and expect average dividend yield of 3.5% and risk-free rate of 6.5% per
annum. Show your arbitrage activity and profit if both indices coverage at 1520 in the last day of
October for RM5 million funds.
Solutions
Step 1: Determine the fair value (true price) – using Cost-of-Carry Model:
F = S + {S(R - Y)T/365)}
F = Futures (forward) Price (FKLI)
S = Cash (spot) Price (KLCI)
R = Risk-free Interest Rate
Y = Expected Average Dividend
T = Days to Maturity
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FUTURES AND OPTIONS (FIN379)
F
= 1490 + {1490 x (0.065 – 0.035) (60/365) }
st
Early of Sept till 31 Oct
*considered as 2 months
F
= 1490 + (7.35)
= 1497
Step 2: Compare to Actual Price (index)
1497 vs 1560 (over-priced)
Therefore SELL Oct futures and BUY physical stock in the cash market.
Table 13: Illustration of the strategy using table (arbitraging)
Cash Market (BMSB)
Today
(early
September)
Later
(October)
Buy physical shares of the index
for RM5 million @ 1490. Hold
temporarily.
Futures Market (BMDB)
Opening Position
Sell 32 October FKLI at 1560
Dispose at
maturity.
Sell Settlement Position
physical shares of the index with
the cost of RM5 million @1520
Buy 32 October FKLI at 1520
Calculations
I. Futures Profit (BMDB)
= (1560-1520) x 32 x RM50
= +RM64,000
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FUTURES AND OPTIONS (FIN379)
II.
Cash (Portfolio) Profit (BMSB)
= (1520-1490) x RM5,000,000
1490
= +RM100,671
III.
Interest Expense
= 0.065 x RM5,000,000 x 60
365
= (RM53,425) *cost of borrowing RM5mil
IV.
Dividend Revenue
= 0.035 x RM5,000,000 x 60
365
= +RM28,767 *dividend of holding RM5mil shares
Total Gross Profit
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= +RM140,013
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FUTURES AND OPTIONS (FIN379)
SELF-ASSESSMENT TASKS
1) Consider the following scenario, then answer the following questions:
March
May
Cash Market (BMSB)
Investor expects to pool RM10
million of stocks portfolio in two
months time.
KLCI has risen to 1771, making
the acquisition of the shares is
more expensive.
Futures Market (BMDB)
Buys May FKLI contracts at 1758
Sells May FKLI contracts at 1773
a) Explain why investors has undertaken this hedging strategy ?
b) How many contracts are required to cover full value of his expected investment?
c) Calculate the profit/loss out of his transaction.
2) You asked your broker to trade six (6) FKLI contracts at a price of 1700 in anticipation of
falling in the future price.
Determine your marked-to-market position based on the following information:
Initial Margin
: 10% of the total contract value
Maintanance Margin : 70% of total initial margin
Day
1
2
3
4
Index
1712
1708
1705
1714
Calculate the profit/loss made at the end of day 4.
3) Explain the term “cash and carry arbitrage”
4) Beta of a portfolio is very important in an investment strategy.
a) What does a beta measure?
b) If the value of beta is 1.1, what does it mean?
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FUTURES AND OPTIONS (FIN379)
st
5) Today, 1 June 2016 , Mr Riz believes that cash and futures market are mismatched. He
wishes to take an arbitrage activity in BMDB.
Currently, KLCI traded at 1560 in spot market while August FKLI is quoted at 1595. He
arranged for three months borrowing of RM1 million at 7.5% per annum with a dividend
yield of 5.0%.
If the prices converged at 1580, show how the transaction is taken place and determine
the total profit/loss.
6) As an investor, Mr Joshua believes that KLCI market will outperform the S&P 500 in the
future. Currently in September, KLCI stands at 1600 while the S&P 500 stands at 1500. The
contract value for S&P 500 is 200 times of its index and the exchange rate is RM3.50 per
USD.
As in December, the indices are as followings:
KLCI
: 1870
S&P 500 : 1619
Based on the information above, answer the followings:
a) What is the strategy should be taken by Mr Joshua?
b) Calculate the contract value and determine the number of contracts involved.
c) Establish the strategy in the form of table, and calculate the profit/loss.
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FUTURES AND OPTIONS (FIN379)
PAST EXAM QUESTIONS
1. You are the fund mnager who manages a portfolio with a current value of RM12 million.
The KLCI is now at 1750 point. You predict the market may be heading towards short-term
volatility and wish to hedge for three (3) months. You have the following information:
Dec 2019
3-month FKLI
1800
Beta
1.50
i.
ii.
Compute the number of contracts that you need to fully hedge. (2 marks)
Show the net effect of hedging strategy if the KLCI falls by 10 percent over the threemonth period and converges with the futures price. (8 marks)
2. Mr.Kama is an active trader and he believes that the current economic condition will give
an impact to the stock price. Based on forecasting, it indicates that the S&P 500 will
outperform the KLCI in the near future. Mr Kama has the following information :
September 2018 S&P 500
2500
September 2018 KLCI
1700
Exchange rate per USD
RM4.50
S&P contract value
USD250 times S&P 500 index
Dec 2018
The KLCI and S&P 500 close at 1900 and 2600, respectively.
i.
Show the profit or loss position in Ringgit Malaysia. (7 marks)
ii.
Explain what would happen if the contract is still open at maturity. (3 marks)
3. A forecast indicates that S&P would underperform KLCI in the near future.
I.
II.
III.
IV.
Mar 2017
July 2016: September 2016 S&P 500
September 2016 KLCI
S&P 500 contract value
Exchange rate
1500
1300
USD250 times S&P 500 Index
RM4.0400/USD
September 2016 : KLCI
S&P 500
1550
1450
Describe the appropriate strategy (2 marks)
Compute the contract number that needs to be traded (6 marks)
Illustrate the strategy in detail (6 marks)
Calculate the gross profit or loss (6 marks)
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FUTURES AND OPTIONS (FIN379)
4. In early September 2017, a futures dealer believed that there is a discrepancy in price
quotation of KLCI futures in BMDB. The current market data are as follow: May 2017
KLCI
Contract Expiry
Dividend Yield
November FKLI
Borrowing cost
Funds Available
I.
II.
III.
IV.
: 1625
: 90 days
: 5%
: 1610
: 7.2%
: RM2.3 million
Calculate the fair value of the November 2017 KLCI Futures contract (3 marks)
Determine whether the November 2017 FKLI contract is over or underpriced. (2 marks)
Create a complete trading activity by assuming both markets settled at 1640 at
maturity. (6 marks)
Calculate the net profit or loss from the trading. (5 marks)
5. Answer the followings:
Mar 2013
I.
If the investor of FKLI contract failed to close the contract on its maturity date,
what will happen to the contract? (3 marks)
II.
Miss Nora plans to enter the FKLI market in April 2011, what are the available
contract months for her? (4 marks)
III.
An investor sold a FKLI at 1550. If the price increased to 1580 at maturity, how
much is his / her return? (3 marks)
IV.
If an investor enters into the FKLI contract in June 2011, when is the maturity date of
the contract? (2 marks)
6. Ms Cempaka , a fund manager has bought a share portfolio valued RM10 million. Currently
in September 2014, the KLCI is at 1530 while December 2014 FKLI is traded at 1500. As an
experienced manager, she decided to take a short position in December FKLI. In order to
protect her portfolio, she hedges 90% of the exposure in the futures with a beta of 1.15.
Later, in December 2014, both the underlying and futures markets settle at price of 1490.
(15 marks)
May 2015
I. State the reason why she needs to do hedging
II. Estimate the number of contracts that she needs to hedge
III. Determine the outcome of the futures market transaction
IV. Calculate the changes in portfolio value
V. Compute the effective price.
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FUTURES AND OPTIONS (FIN379)
5.0 INTEREST RATE FUTURES
5.1
Kuala Lumpur Interbank Offer Rate Futures (FKB)
In Malaysia, short term interest rates are generally categorized into Treasury Bills rate (backed
by Bank Negara) and Kuala Lumpur Interbank Offer Rate (KLIBOR) (backed by strong and big
approved financial institutions).
Advantages of using three-month KLIBOR ;
International standard
Liquidity of the underlying instrument
Volatility of interest rate
Correlation with other Money Market Instruments
The three-month KLIBOR traded in the cash market is the underlying instrument while the
KLIBOR futures (FKB3) are the derivative instrument traded at the BMDB in the form of index
(price).
The intending BORROWER/LENDER in the cash market are in fact the potential
SELLER/BUYER in the futures market.
• Borrower in BMSB = Seller in BMDB
• Lender in BMSB = Buyer in BMDB
The one will borrow money if he experiences a short of cash and the other will lend if he
has a surplus of money.
WHEN THE INTEREST RATE IS EXPECTED TO INCREASE,
THE INDEX (PRICE) WILL FALL, AND VICE VERSA
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FUTURES AND OPTIONS (FIN379)
Contract Specification of 3-Month KLIBOR Futures Contract (FKB3
Underlying Instrument
3-Month KLIBOR Futures Contract (FKB3)
(Ringgit Interbank time deposit in the Kuala Lumpur Wholesale
Money market with a three month maturity on a 360-day year.
Contract Size
RM1,000,000 (quoted in index terms 100 minus yield)
Minimum Price
Fluctuation
Contract Months
0.01% or 1 tick valued at RM25
Trading Hours
First session : 9.00 am – 12.30pm
Second session : 2.30 pm – 5.00 pm
Final settlement Value
Final Trading Day and
Maturity Date
Cash settlement based on the Final Settlement Value.
Trading ceases at 11.00am on the 3rd Wednesday of the
delivery month or the immediate Business day if the 3rd
Wednesday is not a Business Day.
Position Limit
2,000 contracts net gross Open Position for all delivey months
5.2
Quarterly cycle months of March, June, September, and
December up to 5 years forward and 2 serial months
Hedging with FKB
Hedgers are the intending borrowers and lenders.
POTENTIAL BORROWERS are concerned about the RISING INTEREST RATE – higher cost of
borrowing.
POTENTIAL LENDER are concern about FALLING INTEREST RATE – lower operating profit.
I.
Long Hedge
This strategy is taken by potential lenders in anticipating of falling interest rates. (prices will
increase)
So, they will Buy KLIBOR futures now – since the price will increase.
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FUTURES AND OPTIONS (FIN379)
SOLVED PROBLEM
You expect an excess fund of RM200 million in December to be deposited in the KLIBOR
market. Today is October in which 3 month KLIBOR is quoting at 4.5% per annum while
December futures (FKB3) is trading at 95.1 in the BMDB.
In anticipation of falling interest rates, establish your hedging strategy by showing your
effective interest rate (EIR) if the cash rate is trading at 3.8% and Dec. futures at 96.5
Solutions:
Interest rate will fall – therefore price will increase
Strategy – BUY FKB3 today.
Table 14: Illustration of Establishment of a buying (Long Hedge) in the form of table
Today
(Oct)
Later
(Dec)
BMSB ( Cash Market)
Receive notification of RM 200
million excess funds in Dec.
Current interest rate = 4.5%
(Expect ir to fall in dec and the
price to increase - Buy)
Received RM200 million and
deposited @ 3.8% (96.2)
(Lower rate means less interest
revenue)
BMDB (Futures Market)
Opening Position
Buy 200* Dec FKB3 at 95.1
(4.9%)
Offsetting Position
Sell 200 Dec FKB3 at 96.5
(3.5%)
Step 1: Determine the number of contracts
* Number of contracts
= Amount of fund (Principal)
Size of contracts
= RM200,000,000/RM1,000,000
= 200
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FUTURES AND OPTIONS (FIN379)
Step 2: Determine the effective interest rate
I.
Futures position (BMDB)
Futures profit
= (End index– beg index) x basis x no. of contract x min. price fluctuation
= (96.5 – 95.1) x 100 x 200 x RM25
= RM700,000
II. Cash Position (BMSB)
Interest Revenue
= Principal x Rate x Time
= RM200,000,000 x 0.038 x 90/360
= RM1,900,000
Since this is 3 months
KLIBOR, then the number of
days is fixed, 90 days.
III.
Net Effect
= Futures Profit + Cash Position (revenue)
Net Effect
= RM700,000 + RM1,900,000
= RM2,600,000
IV.
EIR
= (Net Effect) / Principal x T
= (RM2,600,000)/(200,000,000 x 90/360)
= 5.2% instead of 3.8% without hedging
Impact of hedging
The lender enjoyed to receive more interest rate (higher return) out of his/her deposit amount.
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FUTURES AND OPTIONS (FIN379)
II.
Short Hedge
This strategy is taken by potential borrowers in anticipating of rising interest rates. (lower price)
So, they will Sell KLIBOR futures now – since the price will decrease.
SOLVED PROBLEM
A company has a special short term borrowing for RM500 million in June. In this agreement, the
co. will be charged 2.5% above KLIBOR. Currently the interest rate is 3.5% and expected to rise
steadily within three months. Today, early April, June futures are quoting at 96.05 in the
BMDB. Assuming in mid June cash rate closed at 5.1% and June futures at 95.00. Show your
hedging benefits as measured by effective interest rate (EIR).
Solution
Interest rate will rise – therefore price will decrease
Strategy – SELL FKB3 today.
Table 15: Illustration of a selling (Short Hedge) in the form of table
Today
(April)
Later
(June)
BMSB ( Cash Market)
Need to borrow RM 500 million in
June. Current interest rate = 3.5%
BMDB (Futures Market)
Opening Position
Sell 500* June KLIBOR futures
(Expect rate to rise and the price to @ 96.05 (3.95% + 2.5% =
decrease - Sell)
6.45%)
Borrow RM500 million at higher
rate of 5.1% + 2.5% = 7.6% (Higher
rate means higher interest cost)
Offsetting Position
Buy 500 Dec KLIBOR futures @
95.00 (5.0% + 2.5% = 7.5%)
Step 1: Determine the number of contracts
* Number of contracts
= Amount of fund (Principal)
Size of contracts
= RM500,000,000/RM1,000,000
= 500
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INTRODUCTION TO FUTURES ANDOPTIONS | MALAYSIAN DERIVATIVES
Step 2: Determine the effective interest rate
I.
Futures position
Futures profit
= (End index– beg. index) x basis x no. of contract x min. price fluctuation
= (96.05 – 95.00) x 100 x 500 x RM25
= RM1,312,500
II.
Cash Position
Interest Expense
= Principal x Rate x Time
= RM500,000,000 x 0.076 x 90/360
= (RM9,500,000)
III.
Net Effect
= Futures Profit + Cash Position (expense)
Net Effect
= RM1,312,500 + (RM9,500,000)
= (RM8,187,500)
IV.
EIR
= (Net Effect)/P x T
= (RM8,187,500)/(500,000,000 x 90/360)
= 6.55% instead of 7.6% without hedging
Impact of hedging
The borrower enjoyed to bear lower interest rate (lower cost of borrowing) out of his/her
borrowing amount.
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FUTURES AND OPTIONS (FIN379)
5.3 Speculating with FKB
Speculative buying and selling activities are the same as in the case of CPO futures and KLCI
futures.
The only different is the formula to calculate the floating profit / loss
Floating profit/loss = (sell – buy) x no. of contracts x 100bp x RM25
In order to test your level of understanding, please
attempt any related question at the end of this chapter.
HAVE FUN TRYING!!!!
5.4 Spreading with FKB
Spreading with FKB is also the same as in the case of CPO and KLCI futures.
The only different is the formula to calculate the total profit / loss
Profit/loss = Spread x no. of contracts x 100bp x RM25
*If the spread is already times with 100bp in the table, there is no requirement to
multiply with the 100bp in order to find the total profit/loss.
In order to test your level of understanding, please
attempt any related question at the end of this chapter.
HAVE FUN TRYING!!!!
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
5.5
Arbitraging with FKB
Unlike CPO and KLCI futures, arbitraging with KLIBOR futures involves the calculation of Implied
Forward Rate (IFR) – the expected future interest rate.
Step 1: Determining IFR
1 + R x (90/360) = 1 + r2 x (t2 / 360)
1 + r1 x (t1 / 360)
OR
IFR =1 + r2 (t2/360)
-1
1 + r1 (t1/360)
x
360
90
Where t1 = length of short period
t2 = length of long period
r1 = the lending/borrowing rate covering the short period
r2 = the lending/ borrowing rate covering the long period
Step 2: Determine the fair value of KLIBOR Futures
FV = 100 – IFR
If it is significantly below or above the fair value, a temporary price distortion has taken
place and
hence, an arbitrage opportunity can be created for immediate and certain
profit.
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FUTURES AND OPTIONS (FIN379)
IN THE CASE OF OVER-PRICED:
make short term borrowing
sell KLIBOR futures,
lend fund until maturity date plus additional three month
roll-over borrowing requirement upon maturity
IN THE CASE OF UNDER-PRICED:
make short term lending
buy KLIBOR futures,
Borrow fund until maturity date plus additional three month
roll-over the lending requirement upon maturity.
SOLVED PROBLEM
In early June, Mr Ben believes that there will be a price mismatch between KLIBOR futures
market (FKB) and the physical KLIBOR market. The following information has been collected:
June 2010
June KLIBOR Futures
3 month KLIBOR rate
6 month KLIBOR rate
:
:
:
4.4%
3.6%
5.1%
September 2010
September 2010 KLIBOR futures converge with the spot rate at 4.8%.
Show the arbitrage strategy should be taken by Mr Ben and calculate the profit or loss if he
wants to borrow RM3 million.
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FUTURES AND OPTIONS (FIN379)
Solutions
Step 1: Determine the IFR
IFR =
1 + R x (90/360) = (1 + 0.051 x (180/360) / (1 + 0.036 x (90/360)
= 6.54%
Step 2: Determine the fair value
FV = 100 - 6.54
= 93.46
93.46 VS 95.6 (overpriced - sell futures)
Step 3: Strategy
make short term borrowing
sell KLIBOR futures,
lend fund until maturity date plus additional three month
roll-over borrowing requirement upon maturity
Table 16: Illustration of strategy in the form of table
Cash Market (BMSB)
Futures Market (BMDB)
June
Borrow RM3 million for 90 days
@ 3.6%
Sell 3 June FKB3 at 95.6
(100-4.4)
Lend RM3 million for 180 days @
5.1%
September
FO_by_IM
Roll over borrowing of RM3
million @ 4.8% for another 90
days (t2-t1)
Buy 3 June FKB3 at 95.2
(100-4.8)
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FUTURES AND OPTIONS (FIN379)
Step 4: Determine the profit / loss
I.
Futures profit (BMDB)
: (95.6 - 95.2) x 100 x 3 x RM25
= RM3,000
II.
Interest revenue (BMSB) : RM3 million x 0.051 x 180/360
= RM76,500
III.
Interest expenses
= (RM 27,000)
= (RM 36,324)
: RM3 million x 0.036 x 90/360
: RM3.027 million x 0.048 x 90/360
Net Profit
= RM 16,176
Amount of roll-over borrowing of RM3,000,000 +
existing interest of previous borrowing, RM27,000.
*As you need to ‘extend’ your borrowing
another 90 days in order to commit for your
lending of 180 days (short of 90 days).
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FUTURES AND OPTIONS (FIN379)
SELF-ASSESSMENT TASKS
1) List any three (3) reasons of using 3-month KLIBOR.
th
2) Today is 13 May 2016 and the FKB3 prices are as follows:
Date/ Month
th
13 May
th
13 July
September
92.30
92.45
FKB3 Settlement Price
October
November
92.39
92.49
92.47
92.65
December
92.50
92.50
Miss Ellina has decided to enter into spread strategy for 2 contracts FKB3 at the end of
rd
th
3 and 4 quarter of the year.
th
a) What is the strategy should be taken by her on 13 May?
th
b) If Miss Ellina decided to offset her position on 13 July, show the net profit/loss if
the commission charged if RM80 per round contract?
3) In early March, Mr Fakhri believes that there will be a price mismatch between FKB3
and the physical KLIBOR market. The following information is gathered.
(Assume he wants to borrow for RM3
million) March 2016
June FKB
: 93.2
3 month FKB rate : 6.0%
6 month FKB rate : 7.5%
June 2016
June 2016 FKB converges with spot rate at 7.2%. Outline the strategy should be taken
by him and determine the profit/loss.
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FUTURES AND OPTIONS (FIN379)
4) Mrs June bought eight (8) September FKB at futures interest rate of 7.68%.
a) What is the price of the FKB?
b) Whwn does her futures contract expire?
c) What is the value of her contract?
Construct her marked-to-market position based on the following information and
determine the total floating profit/loss ,if the initial margin is RM1000 per contract.
Day
Price
FO_by_IM
1
93.66
2
93.48
3
93.23
4
93.11
5
93.29
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FUTURES AND OPTIONS (FIN379)
PAST EXAM QUESTIONS
1.
Give two (2) reason for the three-month KLIBOR popularity. ( 5 marks)
Dec 2019
2.
Assume now is mid November 2019and December 2019 FKB3 contract is trading at
98.50. The 30-day KLIBOR and 20-day KLIBOR are traded at 5.50 percent and 6.50
percent respectively.
i.
Compute the fair value of the futures contract. (5 marks)
ii.
If a trader has RM6 million cash needs, show the profit or loss from the situation
assumimg that at maturity, the December FKB3 converges with the physical rate
at 5.2 percent. (10 marks)
3. In early September, Madam Suraya borrows RM1 million and believes that there may be an
opportunity for arbitrage for December 2016 FKB3. The data are given as follow:
Mar 2017
3 month KLIBOR
6 month KLIBOR
Spot month FKB3
3 month FKB3
5.5%
6.5%
96.00
94.00
Assuming in December 2016, the December FKB3 converges with the physical rate at 7.0%.
I.
II.
III.
Determine the fair value fro December 2016 FKB3 (4 marks)
Prepare the strategy (8 marks)
Compute the profit and loss for the above strategy. (8 marks)
4.
Miss Safira is an active speculator. By looking at the current economic situation,
she expects that the interest rate will fall for the next few months. Therefore, she
decided to long seven
(7) September 2017 FKB3 contracts at the yield of 5.8% today.
May 2017
I.
II.
Determine the price for September FKB3 quoted today (2 marks)
Calculate the contract value of September 2017 FKB3 (2 marks)
III.
Assuming that Miss Safira is required to pay 6% initial margin of the contract value,
prepare the marked-to-market position based on the following settlement prices.
(14 marks)
Day
1
2
3
4
5
Price
95.63
95.28
95.07
95.80
96.00
IV.
Compute the realized profit/loss from the above above trading (2 marks)
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FUTURES AND OPTIONS (FIN379)
5. Mr. Rahman decides to observe the following KLIBOR futures
quotations:
May 2015
September 2014 futures
December 2014 futures
April 2014
95.60
97.40
August 2014
96.50
95.90
a) He decides to open a spread position in April 2014 and close out in August 2014. The
spread is expected to narrow between the two contract months. (15 marks)
I.
Calculate his gross profit or loss if he trades 8 contracts for each contract month.
II.
Show his net profit or loss if he has to pay commission charges of RM100
per contract.
III.
Calculate his new gross profit or loss if he decides to trade 15 contracts for each
contract months
b) Provides short answer for the following question. (5 marks)
I.
State his prediction of the market direction if a speculator buys 15 September FKB3
at a price of 95.30.
II.
Calculate the profit or loss for this transaction when the speculator closes
his position by selling 15 September FKB3 at a price of 96.70
6.
Speculator has long six (6) March 2016 FKB3 contracts at yield of 6% today in
anticipation of
falling interest rates for the next few months.
Mar 2016
I.
II.
III.
FO_by_IM
Determine the price on March 2016 FKB 3 quoted on today (2 marks)
Show when is the last trading day of the FKB3 contract. (2 marks)
Compute the value of FKB3 contract. (2 marks)
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FUTURES AND OPTIONS (FIN379)
6.0 BOND FUTURES
6.1
Bond Futures (FMG)
The underlying instrument is The Malaysian Government Securities (MGS) so called 5 year
MGS, and the derivative is also the 5 year MGS Futures (FMG5)
Upon maturity, the buyer and seller of FMG5 contracts will settle in cash based on a final
settlement value
Contract Specification of 5-year Malaysian Government Securities Futures (FMG5)
Underlying Instrument
5-year Malaysian Government Securities Futures (FMG5)
Contract Size
Minimum Price
Fluctuation
Contract Months
RM100,000
0.01 or RM10
Trading Hours
First session : 9.00am – 12.30pm
Second session : 2.30 pm – 5.00pm
Final Settlement
Final Trading Day and
Maturity Date
Cash Settlement
Trading ceases at 11.00am on the 3rd Wednesday of the
delivery month or the immediate Business day if the 3rd
Wednesday is not a Business Day.
6.2
Four nearest Quarterly cycle month (March, June, September,
December)
Hedging with FMG
The concept of hedging with FMG is quite similar with KLIBOR as the investors are concern
about the RISING/FALLING in interest rate.
FALLING in interest rate will lead the price to rise up, thus LONG HEDGE strategy should
be taken.
RISING in interest rate will lead the price to fall down, thus SHORT HEDGE strategy
should be taken.
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FUTURES AND OPTIONS (FIN379)
I.
Long Hedge
Long Hedge strategy is taken in anticipation of FALLING in interest rate of MGS.
Investor will BUY FMG now (today) at lower price and will SELL FMG later at higher price.
SOLVED PROBLEM
ABC Bank intends to purchase 500 March MGS in one month time (today - February). In the
futures market, the price is quoted at 112.95 and the current interest rate is 8.50%. ABC is
concern of falling interest rate between now and when the MGS are issued (March). To hedge
against falling interest rate ABC bank decides to buy MGS futures.
In March, the interest rate falls as predicted to 8.0% and MGS futures are quoted at 113.13.
Show the hedging benefit.
Solutions
Interest will fall – Price will increase
Strategy – BUY FMG today.
Table 17: Explanation of a buying (Long Hedge) in the form of table
BMSB ( Cash Market)
BMDB (Futures Market)
Today
(Feb)
Bank intends to buy RM 50 million
5-Year MGS when they are
auctioned in March. They are
concerned interest rates may fall.
Current interest rates are 8.50%.
Opening position
Buy 500* March FMG at
112.95
Later
(Mar)
Bank buys RM 50 million of 5-Year
MGS. Bond yields have fallen from
8.50% to 8.00% making the bonds
more expensive.
Offsetting position
Sell 500 March FMG at 113.13.
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FUTURES AND OPTIONS (FIN379)
Step 1: Determine the number of contracts
* Number of contracts
= Amount required
Size of contracts
= RM50,000,000/RM100,000
= 500 contracts
Step 2: Determine the effective price
I.
Futures Position (BMDB)
Futures Profit
= (sell – buy) x no. of lot x 100 bp x minimum price fluctuation
= (113.13 – 112.95) x 500 x 100 x RM10
= RM90,000
II.
Cash Position (BMSB)
Cash Expenses
= Ending Price - Beginning Price x Amount Required
Beginning price
= (113.13 – 112.95) x 50,000,000
112.95
= RM79,681.27( Cost of purchasing)
The cost to buy the bond has
increased due higher price of
bonds.
III.
Net Effect
Net Effect
= Futures profit – cash expense –amount required
= RM90,000 - RM79,681.27 - RM50,000,000
= - RM49,989,681.27
Minus sign
for long
hedge (signal
of cash
outflows)
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FUTURES AND OPTIONS (FIN379)
IV. Effective Price
II.
= Net Effect x Ending Futures Price
Amount of Bond Required
= RM49,989,681.27 x 113.13
50,000,000
= 113.11 (Bank buys the bond at lower price index as compared
to 113.13)
Short Hedge
Short Hedge strategy is taken in anticipation of RISING in interest rate of MGS.
Investor will SELL FMG now (today) at higher price and will BUY FMG later at lower price.
SOLVED PROBLEM
ZZ Bank intends to sell 100 March MGS in one month time (today - February). In the futures
market, the price is quoted at 113.13 and the current interest rate is 5.50%. ZZ is concern of
rising interest rate between now and when the MGS are issued (March). To hedge against rising
interest rate ZZ bank decides to sell MGS futures.
In March, the interest rate rises as predicted to 6.0% and MGS futures are quoted at 112.95.
Show the hedging benefit.
Solutions:
Interest will rise – Price will decrease
Strategy – SELL FMG today, buy back later at lower price.
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FUTURES AND OPTIONS (FIN379)
Table 18: Illustration of a selling (Short Hedge) in the form of table
BMSB ( Cash Market)
BMDB (Futures Market)
Today
(Feb)
Manager intends to sell RM10
million 5-Year MGS when the new
MGS auctioned in March. He is
concerned interest rates may rise.
Current interest rates are 5.50%.
Sell 100* March FMG at
RM113.13
Later
(Mar)
Manager sells RM 10 million of 5Year MGS with lower price due to
bond yields have risen from 5.50%
to 6.00% making the bonds
cheaper.
Buy 100 March FMG at
RM112.95
Step 1: Determine the number of contracts
* Number of contracts
= Amount required
Size of contracts
= RM10,000,000/RM100,000
= 100 contracts
Step 2: Determine the effective price
I.
Futures Position
Futures Profit = (sell – buy) x no. of lot x 100 bp x minimum price fluctuation
= (113.13 – 112.95) x 100 x 100 x RM10
= RM18,000
II.
Cash Position
Cash Revenue = Ending Price - Beginning Price x Amount Required
= (112.95 – 113.13) x 10,000,000
113.13
= - RM 15,910.90 (less in revenue)
The revenue of selling the
bonds has fallen due lower
price of bonds.
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INTRODUCTION TO FUTURES ANDOPTIONS | MALAYSIAN DERIVATIVES
III.
Net Effect
Net Effect
= Futures profit + cash revenue + amount required
= RM18,000 + (RM15,910.90)+RM10,000,000
= RM10,002,089.10
Pl us sign for
short hedge
(signal of
cash inflows)
IV.
6.3
Effective Price = Net Effect x Ending Futures Price
Amount of Bond Required
= RM10,002,089.10 x 112.95
10,000,000
= 112.97
Speculating with FMG
The concept of speculating with FMG is similar to other derivative instruments previously.
The only different is the formula to calculate the floating profit / loss
Floating profit/loss = (sell – buy ) x no. of contracts x 100bp x RM10
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FUTURES AND OPTIONS (FIN379)
6.4
Spreading with FMG
SOLVED PROBLEM
Assuming Miss Mia is bullish about the underlying market. She expects that the distant
contract month would typically fall more than the nearby contract month. The basis is
expected to be widening.
Establish the strategy based on the below information and calculate the profit/loss for this
transaction.
May 31,2016
June FMG3
Sept FMG3
Distant contract month is Sept.
122.70
122.60
June 10,2016
June FMG3
Sept FMG3
122.50
121.25
Solutions:
Distant contract month would typically fall more than the nearby contract month. So, here
we CANNOT simply said that we are going to sell June FMG3 and simultaneously buy Sept
contract today (based on higher quoted month will be sold).
As for this type of question (widening strategy), we need to look at the distant contract month
prices. Here, Sept would be our distant contract month.
st
By referring to Sept FMG3, the price quoted for today (as at May 31 ) is higher than price later
th
(June 10 ).
So,the strategy should be taken is to SELL Sept FMG3 and simultaneously BUY June FMG3
today.
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FUTURES AND OPTIONS (FIN379)
Table 19: Illustration of the question using table (spreading)
June Futures
Sept Futures
Buy 1 June FMG3 at
Sell 1 Sept FMG3 at
122.60
Spread (bp)
Today
May 31
st
122.70
Later
th
June 10
Sell 1 June FMG3 at
122.50
( 0.1)
Buy 1 SeptFMG3 at
121.25
1.25
( 0.2)
Spread (bp)
1.15
1.35
Solutions
June FMG3
: (122.50 – 122.70) x 1 x 100 x RM10 = (RM200)
Sept FMG3
: (122.60 – 121.25) x 1 x 100 x RM10 = RM1,350
Gross profit / loss
: (RM200) + RM1,350
= RM1,150
OR,
1.15 x 1 x 100 x RM10
6.5
= RM1,150
Arbitraging with FMG
It is quite complicated as it involved either buying / selling physical MGS and simultaneously
selling/buying MGS Futures.
This is because MGS is rarely trading in its physical secondary market because the holder needs
to hold until maturity.
Participants are normally from the financial institutions or cash rich institution such as EPF
which buy because of statutory requirements.
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FUTURES AND OPTIONS (FIN379)
SELF-ASSESSMENT TASKS
1. A manager of unit trust company wants to buy RM50 million of 5-year MGS and he is
worried that the interest rate will fall in December. He plans to hedge in order to cover the
expected loss in the cash market. Today in September, interest rate is currently at 4.55%
and FMG at BMDB is quoted at 120.50. (14 marks)
Assume in December, you obtained the following information:
FMG
: 122.45
Bond Yield
: 3.90%
Determine the profit/loss out of the hedging transaction and the effective interest rate
from the above transaction.
2. Speculators believe that price of FMG5 contract at BMDB will be downward direction in the
near future. Mr Abu asked his broker to trade 10 FMG5 contracts at the price of 232. He is
required to pay initial margin of RM9,000 per contract and maintenance margin is 70% of
the initial margin. Below are the settlement price of FMG5 contracts for the five days of
trading.
Day
1
2
3
4
5
I.
II.
III.
IV.
Price
229
227
234
223
221
Indicate the total contract value of the FMG5 contracts (2 marks)
Calculate the initial margin and maintenance margin (2 marks)
Prepare his marked-to-market positions (8 marks)
Explain is there is any call margin. (2 marks)
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FUTURES AND OPTIONS (FIN379)
PAST EXAM QUESTIONS
1. Assuming Mr. Chen is bullish about the prospect of 5 year MGS. He is asks his broker to buy 5
lots of FMG5 contracts today at 112.20 at BMDB. He is required to pay initial margin of
RM10,000 and maintain RM8,000 per contract. Referring to the closing prices below :
Dec 2019
i.
ii.
Day
Closing prices
1
112.23
2
112.29
3
112.38
4
112.25
5
112.23
Show his marked to market position. (8 marks)
Determine the total profit or loss. (2 marks)
2. Mr. Qareem has long 20 units of November FMG3 at 119.50. He is required to pay RM2,000
initial margin per lot and should maintain 40% from the initial margin.
Mar 2017
Day
1
2
3
4
5
Price
119.60
119.65
119.63
119.55
119.52
I.
II.
III.
Prepare his marked-to-market position (12 marks)
Estimate the realized profit or loss for the trading (2 marks)
th
Show the leverage effect on the 5 day of trading when he closes the
contract. (6 marks)
3. a) Identify any four (4) potential users of MGS futures (6 marks)
May 2017
b) Assume now is August 2017 and as a trader, you believe that the underlying market is
going to be bearish. You expect that the distant contract month would typically fall
more that the nearby contract month. Hence, the basis is widening. The information
below is given to you.
August 31,2017
I.
II.
September 10,2017
Sept FMG5
108.13
Sept FMG5
106.17
December FMG5
107.43
December FMG5
105.02
Illustrate the trading activities above based on the information given. (8 marks)
Calculate the profit or loss for this transaction (6 marks)
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
7.0 INTRODUCTION TO OPTIONS
7.1
Definition of Options
An option is a contract that gives a buyer the right (choice) without obligation to buy or sell an
underlying instrument (specified asset) at the exercise price (specified price) until maturity of
contract (specified time).
On the other hand, a seller has an obligation to sell or buy the underlying instrument only if
exercised by the buyer.
Option
Buyer
Give him the
RIGHT to buy or
sell a particular
asset
BUT does not
have the
OBLIGATION
Seller
contract
Has an
OBLIGATION if
exercised by a
buyer
BUT does not
have RIGHT
The concept is as simple as putting some deposit (called premium) to buy something at an
agreed price and time. As a buyer you have a right to buy or not to buy and the deposit will be
forfeited if the agreement is dishonoured.
Meaning that the buyer has to pay deposit in order to acquire a right while a seller will
receive a deposit in order to place him with an obligation.
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FUTURES AND OPTIONS (FIN379)
7.2
Types of Options
Call (buy) Option
Buyer of the option contract, be GIVEN A RIGHT TO BUY a
particular asset at or before a particular of time at a specific
price.
Put (sell) Option
Also a buyer of the option contract, be GIVEN A RIGHT TO SELL
a particular asset at or before a particular of time at a specific
price.
Hmmmm…both are the buyers of the options???
Sounds confusing? Never mind, we will explore further
in the next chapter….
The seller (writer) of the
option contract has no right but he has to oblige by the decision of
buyer to exercise or not.
7.3
Features / Elements of Options
Underlying asset
For KLCI Options, underlying instrument is KLCI.
Exercise price (strike
price)
Current Market Price
Price that the buyer (holder) has the right to sell or buy the
underlying assets from or to a seller (writer)
Based on the actual price of underlying.
Example: the price of KLCI option is derived from the actual current
price of the KLCI
Option market price which is determined by bid and ask
Maturity date of the options contract
Settlement by cash at maturity date
Types of option contract with different in the expiry date and price
Refers to the options contract which has the same expiration date
but different exercise price.
Premium
Expiration date
Time to exercise
Classes of option
Series of Options
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FUTURES AND OPTIONS (FIN379)
7.4
I.
Options Pricing and Moneyness
Value of Options
Value of Options is determined by the current market price but, due to the common
fluctuations of the underlying stock prices, the exercise price may be above, at par or
below the current market price.
Buyer may decide to exercise or not based on the situation below:
In-the-money – the call option is PROFITABLE to be exercised
Out-of-the-money - the call option will NEVER BE EXERCISED (LOSS)
At-the-money - the buyer is NEITHER LOSS NOR GAIN to exercise the call or put
option
Table 7.4.1 :The Relationship between Current Market Price and Exercise Price of Call and Put
Option
Current Market Price
> Exercise price
= Exercise price
< Exercise price
II.
Call Option
Put Option
In - the – money
At - the – money
Out-of– the–Money
Out-of-the– money
At - the - money
In - the - money
Basic Properties of Option Prices
Option prices can be divided into 2 parts namely; Intrinsic value (IV) and Time value (TV)
Option Premium = IV + TV *premium itself is the price for the option.
HINT: Frequently asked question (FAQ)
“What is the price of the options?”
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
Intrinsic Value (IV)
IV of call option = Market Price – Strike
Price
Time value (TV)
TV refers to the diff. bet. the option
premium and intrinsic value (TV = OP – IV)
IV can never be negative because the
Although the IV is zero, option still has TV
option holder will not exercise if it is OTM
until expiration
III.
Factors Affecting Option Prices
Price of the Underlying Asset – The higher the price of underlying, the higher price of
option
Strike Price – A call option with a higher strike price will have a lower option price
because of lower intrinsic value.
Expiration Time – The longer the time to expiration, the higher the premium
Interest Rate – The higher the interest rate, the cheaper the option
Market Volatility – Premium increase as the volatility increase
Dividends – After dividends are paid, the share price normally decline and this will affect
the price of call option.
7.5
American vs European Option
The key difference between American and European options relates to when the options can
be exercised:
A European option may be exercised only at the expiration date of the option, i.e. at a
single pre-defined point in time.
An American option on the other hand may be exercised at any time before the
expiration date.
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FUTURES AND OPTIONS (FIN379)
SELF ASSESSMENT QUESTIONS
1. Explain the difference in risk taken by the buyer and seller of an option (5 marks)
2. Differentiate between the intrinsic value and time value of an option (5 marks)
3. Explain the difference between American Option and European Option (4 marks)
PAST EXAM QUESTIONS
1. List any five (5) factors that affect options prices (5 marks)
May 2017
2. Mewah Putra Holdings’ stock is currently valued at RM8.00 per share. Its RM7.50 call and
put options are quoted at RM0.85 and RM0.50 respectively. These two options have the
maturity of 3 months. Estimate the time value and intrinsic value for each options.
(8 marks)
Mar 2017
3. Define intrinsic value for option trading (3 marks)
Oct 2016
4. List five (5) features in option contract (5 marks)
May 2015
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
8.0 OPTIONS STRATEGIES
Introductions (KLCI Options / OKLI )
The contract size for KLCI Options is the index point of KLCI x RM100.
KLCI Options can only be exercised on the last day of trading which is based on
European Style.
The settlement is via cash settlement because there is no physical delivery of the basket
of shares of Bursa Malaysia.
Underlying Instrument
Contract Specification of OKLI
FBM KLCI futures (FKLI)
Contract Size
One FKLI contract
Type
European Style
Tick size
0.1 index valued at RM5
Contract Months
Spot month and the next month, and the next 2 calendar
quarterly months.
Quarter months :March, June, September, and December
Trading Hours
First session : 8.45 am – 12.45 pm
Second session : 2.30 pm – 5.15 pm
Settlement of Option
Exercise
In the absence of contrary instructions delivered to the Clearing
house, an option that is in-the-money shall be automatically
exercised.
Speculative Positions Limit 10,000 FKLI-equivalent contracts ( a combination of OKLI and
FKLI contract), net on the same side of the market in all contract
months combined.
Final Trading Day and
Maturity Date
Settlement
Type
FO_by_IM
The last Business Day of the contract month
Cash Settlement based on the Final Settlement value
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FUTURES AND OPTIONS (FIN379)
8.1 Basic Strategies of Options
An investor can reduce his exposure in the stock market by establishing an option strategy in
the options market, namely;
Long Call
Long Put
Short Call
Short Put
Investor goes LONG ON CALL or LONG ON PUT are the holder of the option contract
and they have 3 alternatives:
DO NOTHING and LET OPTION EXPIRE if at expiry, it is out-of-the-money
EXERCISE THE OPTION WHEN in-the-money for realizing profit.
For call option - buy first the underlying in BMDB at lower price and sell later at
higher price in Bursa Malaysia.
For put option, buy first the underlying in Bursa Malaysia at lower price and sell
later at higher price in the BMDB)
SELL the same option and CLOSEOUT his position prior maturity.
HINT : BUYER of the options
Investor goes SHORT ON CALL or SHORT ON PUT have only 2 alternatives:
DO NOTHING and WAIT FOR BUYER to exercise or not to exercise
BUY the same option and CLOSEOUT his position prior maturity.
HINT : SELLER/WRITER of the options
I.
Long Call
Call option gives the holder of the option the RIGHT TO BUY the underlying assets, but not the
obligation.
A call option is bought when one expects the underlying index or stock to be very BULLISH.
(expectation of increase in price)
This strategy usually has a LIMITED LOSS and UNLIMITED PROFIT.
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
SOLVED PROBLEM
Mr Joe bought a call option of KLCI with strike price 1400 at a cost (premium) of 75 points. The
KLCI (current price) then moves to 1500 points.
Calculate his profit/loss.
Solutions
Strategy taken is Long Call – expects price to increase.
When the price moves from 1400 to 1500 points – market does favour him (ITM)
Action – He should exercise the options.
Market favours due to it meets the expectation of LONG CALL
investor (which expects price to increase, ie; 1400 to 1500).
Action: Since he is the buyer (referring to position of LONG),
then he has the right to EXERCISE the in-the-money options
(profitable options).
Calculations
I.
Pay –off profit/loss
Profit = (Current Price (CMP) – Exe Price (X) – Premium (pm)) x RM 100
*if exercised by buyer
OR
Loss = Premium *if not exercised by buyer
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FUTURES AND OPTIONS (FIN379)
Profit = (1500 – 1400 – 75) RM100
= RM2,500
Buyer choose to exercise the
options, so use the first
formula.
II.
Break – even point
BEP = X + Pm
BEP
III.
= 1400 + 75
= 1475 points
Pay – off diagram
PM (+)
X=1400
BE = 1475 ITM
ATM
OTM
-75
HINT: Buyer would not exercise the option when the price falls below 1400 points. (OTM)
Any price above 1475 will bring in profit to the investor.
What if price
falls between
1400 to 1475
Any price in the range of 1400 to
1475 (ATM), it is advisable to
exercise the options as it will
minimize the loss to investor.
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
INTRODUCTION TO FUTURES ANDOPTIONS | MALAYSIAN DERIVATIVES
SOLVED PROBLEM
Mr Arif bought a call option of KLCI with strike price 1700 at a cost (premium) of 75 points. The
KLCI (current price) then moves to 1500 points.
Calculate his profit/loss.
Solutions
Strategy taken is Long Call – expects price to increase.
When the price moves from 1700 to 1500 points – market does not favour him (OTM)
Action – He should not exercise the options.
Calculations
If buyer not exercised the option, loss only to premium paid.
Loss = 75 points or 75 x RM100 (RM7,500)
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
II.
Short Call
An investor sells a call option when he expects the MARKET TO BE BEARISH (expectation of
falling in price) or STABLE over a period of time.
He may write a call option in order to make money from the premium.
This strategy usually has a LIMITED PROFIT and UNLIMITED LOSS.
SOLVED PROBLEM
Assume that an investor is bearish on XYZ shares and expects the stock price to fall in near
future. He decided to write on XYZ Call with a strike price of RM5,000 of 1,000 shares and
premium 40 cents per share. At expiry, the XYZ stock closed at RM6.00 per share. What is the
possible pay off for the investor?
Solutions
Strategy taken is Short Call – expects price to decrease.
When the price moves from RM5 to RM6 per share – market does not favour him,however
he is the writer (seller) and has no right. This condition will favour the buyer of the call
option (Long Call). So,buyer will exercise the ITM options.
Calculations
I.
Pay –off profit/loss
Profit = Premium (if not exercised by buyer)
Loss = ( X – CMP + Pm ) * if exercised by buyer
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FUTURES AND OPTIONS (FIN379)
HINT: Please take note on this……..
If you are the writer (seller), you DON’T have the right. You
must depend on the decision made by buyer.
*In this case, you should think in the perspective of buyer, first.
Buyer will exercise, so you will bear the loss.
Loss
= RM5 – RM6 + RM0.40
Since you are the seller,
you need to add the
premium received.
= (RM0.60 per share )
Or
(RM60)
(RM0.60 x 100 shares ) * 1 lot consists of 100 shares.
II.
Break – even point
BEP = X + Pm
BEP
= RM5 + RM0.40
= RM5.40
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FUTURES AND OPTIONS (FIN379)
III.
Pay-off diagram
Pm
+ 0.40
X= 5.00
ITM
ATM
BE = 5.40
FO_by_IM
CMP
OTM
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FUTURES AND OPTIONS (FIN379)
III.
Long Put
Put option gives the holder of the option the RIGHT TO SELL the underlying assets, but not
the obligation.
A put option is bought when one expects the underlying index or stock to be very
BEARISH
This strategy usually has a LIMITED LOSS and UNLIMITED PROFIT.
SOLVED PROBLEM
An investor bought a September put option with an exercise price of 1350 that has a premium of
10 index points. The current situation indicates that the market is likely to be very bearish. At
expiry, the current stock index stands at 1320 points. What will the investor do?
Solutions
Strategy taken is Long Put – expects price to decrease.
When the price moves from 1350 to 1320 points – market does favour him (ITM)
Action – He should exercise the options.
Calculations
I.
Pay –off profit/loss
Profit = ( X – CMP –Pm) x RM 100*if exercised by buyer
Loss = Premium *if not exercised by buyer
Profit = (1350 – 1320 – 10) RM100
= RM2,000
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FUTURES AND OPTIONS (FIN379)
II.
Break – even point
BEP = X - Pm
BEP
= 1350 - 10
= 1340 points
III.Pay-off diagram
Pm
ITM
CMP
-10
OTM
BE 1340
X=1350
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FUTURES AND OPTIONS (FIN379)
IV.
Short Put
Investor shorts a put option means he has COMMITTED (OBLIGATION) TO BUY the underlying
assets at the strike price before or at a specific date.
His expectation is that the price to INCREASE above the exercise price.(BULLISH)
His strategy usually has a LIMITED PROFIT and UNLIMITED LOSS.
SOLVED PROBLEM
You bullish on ABC stocks which are priced at RM6.50 each. You can sell the put option with an
exercise price of RM6.50 for a premium of RM0.45. If at expiration of the put option, the ABC
share price is RM7.20. Show the pay off if this strategy is exercised for 1,000 shares.
Solutions
Strategy taken is Short Put – expects price to increase.
When the price moves from RM6.50 to RM7.20 per share – market does favour him,
however he is the writer and has no right. This condition will not favour the buyer of the
put option (Long Put). So, buyer would not exercise the OTM options.
Calculations
I.
Pay –off profit/loss
Profit = Premium (if not exercised by buyer)
Loss = ( CMP – X + Pm ) * if exercised by buyer
Profit = RM0.45 @ RM45 (limited to premium only)
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FUTURES AND OPTIONS (FIN379)
II.
Break – even point
BEP = X - Pm
BEP
= RM6.50 - RM0.45
= RM6.05
III.Pay-off Diagram
PM
RM0.45
ITM
BE = RM6.05
OTM
The investor of Short
Put options will bear
UNLIMITED LOSS if
price falls below
RM6.05
FO_by_IM
CMP
X = RM6.50
The investor of Short
Put options will have
LIMITED profit if price
goes beyond RM6.50
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FUTURES AND OPTIONS (FIN379)
Uses and Implications
A BUYER of option has a LIMITED LOSS and UNLIMITED PROFIT (Long call & Long Put)
A SELLER has a LIMITED PROFIT but UNLIMITED LOSS (Short Call & Short Put)
A limited loss for a buyer means a limited profit for a seller
Unlimited profit for a buyer implies for unlimited loss for a seller
HINTS…..!!!!
Table 8.1 : Summary of pay-off profile of basic strategies
Strategy
Profit Pay-Off
Loss Pay-Off
Break-EvenPoint
CMP-X-PM
(unlimited)
PM (Limited)
X+PM
PM (limited)
X- CMP + PM
(unlimited to entile
strike price)
X+PM
X-CMP - PM
(unlimited)
PM (Limited)
X-PM
PM (limited)
CMP-X + PM
(unlimited to entire
strike price)
X-PM
Pay-Off
Diagram
Long Call
Short
Call
Long Put
Short Put
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
8.2
Synthetic Strategies
Synthetically, an investor can combine two out four basic option strategies simultaneously, so
called in the form of straddle, strangle or spread.
Investor can either taking of the
same position for different options, or taking different
position for the same option.
Synthetic Requirements
Factors to be considered in establishing the synthetic strategy;
Type of option – either the same option or different options
(call or put)
Type of position – either
the same or different position (long or
short) to be undertaken
Level of exercise price – either the same (selling = buying )
(ATM) or different exercise price (buying > selling)(OTM) or
(buying < selling) (ITM).
I.
Straddle Strategy
Straddle means stretching side by side from one point or taking the same position for both
options (has a right to buy and sell) with the SAME buying and selling exercise price.
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FUTURES AND OPTIONS (FIN379)
Long Straddle
Buy (same position as a buyer) a call and put option (different option) simultaneously at the
same price by paying both premium.
Long Call + Long Put
As a buyer, he has a right to buy for a call option and right to buy for a put option.
An investor interested in the straddle when he foresees the market is highly volatile but
not certain of the direction. One option will give profit and the other loss
SOLVED PROBLEM
An investor bought a September call option of XYZ stock and a September put option of a
similar stock with exercise price of RM4.00 each and a premium of RM0.21 and RM0.14
respectively. Show the profit and loss.
Solutions
Long call
Long put
RM4.00
RM4.00
RM0.21
RM0.14
Calculations
Unlimited Profit
RM4.35≤ CMP ≤RM3.65
Limited Loss
Total Premium 0.21 + 0.14
= RM0.35
Break even Price
Long call + total pm
RM4.00 + RM0.35 =
RM4.35
Long put – total pm
RM4.00 – RM0.35 =
RM3.65
*combination of premium for *in determining the BE price,
long call and long put.
we should consider the total
premium for both options.
* Refer to the diagrams
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FUTURES AND OPTIONS (FIN379)
Pay-off diagram (Long Straddle)
profit
Strategy : Long Put
Strategy : Long Call
BE=3.86
BE=4.21
0
-0.21
-0.14
X=4.00
X=4.00
BEP
LP=3.65
BEP
LC=4.35
X=4.00
Strategy: Long Straddle
Short Straddle
It is opposite of a long straddle. Short straddle combines a short call and a short put with the
same exercise price.
Short Call + Short Put
Investor is selling both options and he will receive a sum of two premiums.
This strategy is used when the market is expected to be quiet for sometimes.
SOLVED PROBLEM
An investor sold a September KLCI call option of XYZ stock and a September KLCI put option of a
similar stock with exercise price (index) of 1500 each and a premium of 15 points for both
options. Show the profit and loss.
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
Solutions
Short call
Short put
1500 15
1500 15
Calculations
Unlimited Loss
Limited Profit
1530 ≤ CMP ≤ 1470
Break even Price
Short call + total pm
Total Premium 15 + 15= 30
1500 + 30 = 1530
Long put – total pm
1500 – 30 = 1470
*combination of premium for *In determining the BE price, we
should consider the total
short call and short put.
premium for both options.
* Refer to the diagrams
Pay-off diagram (Short Straddle)
Strategy : Short Put
Strategy :Short Call
15
15
BE=1485
BE=1515
X=1500
X=1500
30
BEP
SC = 1530
BEP
SP = 1470
X=1500
Strategy : Short Straddle
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
II.
Strangle Strategy
Strangle means investors go against the market which they usually involve buying or
selling an OTM put and OTM call options.
It requires investor to buy or sell call and put options which has a DIFFERENT EXERCISE
PRICES.
Since it is OTM options, the exercise price of a long call/(short call) > long put /(short
put) (buying price > selling price)
Long Strangle
It is quite similar to long straddle except that it goes with different in exercise prices.
Long Call + Long Put
SOLVED PROBLEM
An investor buys a March KLCI call option at an exercise price of 1050, premium 15 and a March
KLCI option put option with an exercise price of 900, premium 35. Show the pay-off
Solutions
Long call
1550 15
Long put
1400 35
FO_by_IM
Do you notice,
of the different
exercise
prices??
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FUTURES AND OPTIONS (FIN379)
Calculations
Unlimited Profit
Limited Loss
1600 ≤ CMP ≤ 1350
Break even Price
Long call + total pm
Total Premium 15 + 35= 50
1550 + 50 = 1600
Long put
– total pm
1400 – 50 = 1350
*combination of premium for *in determining the BE price,
long call and long put.
we should consider the total
premium for both options.
* Refer to the diagrams
Pay-off diagram (Long Strangle)
Strategy: Long Call
Strategy : Long Put
BE=1365
BE =1565
-15
-35
X=1550
BE
BE
LP=1350
LC=1600
-50
X=1400
-
XLP=1400
XLC=1550
Strategy: Long Strangle
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FUTURES AND OPTIONS (FIN379)
Short Strangle
It is opposite of long strangle.
Writing an OTM call and put with different exercise prices (short call X price > short put).
SOLVED PROBLEM
An investor is issuing RM10.50 call option for 20 cents and RM8.00 put option for 30 cents.
Show the pay-off profile of profit and loss.
Solution:
Short call
Short put
RM10.50
RM8.00
RM0.20
RM0.30
Calculations
Unlimited Loss
RM11.00 ≤ CMP ≤RM7.50
Limited Profit
Total Premium RM0.20+
RM0.30= RM0.50
Break even Price
Short call + total pm
RM10.50 + RM0.50=
RM11.00
Long put – total pm
RM8.00 – RM0.50=
RM7.50
*combination of premium for *in determining the BE price,
we should consider the total
long call and long put
premium for both options.
* Refer to the diagrams
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
Pay-off diagram (Short Strangle)
Strategy :Short Call
Strategy :ShortPut
0.20
X= 8.00
X=10.50
0.30
BE=10.70
BE=7.70
XSP=8.00
XSC=10.50
0.50
BE
LP=7.50
BE
SC=11.00
Strategy : Short Strangle
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
SELF ASSESSMENT QUESTIONS
1. Supposed you bought 1000 shares of Maybank September RM11 Put Option for RM0.90
a) Determine
i.
What is your expectation when entering into the strategies
ii.
The price of the option
iii.
The expiry date
iv. The underlying asset
(10 marks)
b) If Ms Tasha is the seller of this option, and the price of the Maybank stocks on the last
day of trading was RM12.50, determine:
i.
The reason of selling the option (2 marks)
ii.
The action that will be taken by you (4 marks)
iii.
How much is your profit (loss) (4 marks)
2. (a) Madam Rokiah currently buys a March call option of Westport Green Berhad at an
exercise price of RM8.00 with a premium of RM0.50. The current market price is RM9.50
per share.
I.
II.
III.
V.
Compute the maximum loss (1 mark)
State whether the profit is limited or unlimited (1 mark)
Compute the breakeven point (2 marks)
Compute the payoff if the price is RM12.00 on maturity date. (4 marks)
(b) Mr.Abu has a call option with an exercise price of RM10 and a premium of RM0.20. Calculate
Mr. Abu’s profit if the stock price is RM9, RM10, RM11 and RM12. (8 marks)
3.
Type
Exercise
Option Price
Price
Call
600
12
Call
650
10
Put
600
6
Put
650
7
Based on the above quotations,sketch a payoff diagram and label for the:
I. Long Put
II. Long Strangle
III. Short Call
IV. Short Straddle
(16 marks)
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
PAST EXAM QUESTION QUESTIONS
1. The following information is available at BMDB:
Option Types
Call
Call
Put
Put
Feb 2020
Strike Price
1610
1570
1610
1570
Option Price
45
40
30
25
Sketch the pay-off diagrams by determining the breakeven, maximum profit and maximum loss
for the following strategies:
i. Short put at maximum revenue (5 marks)
ii. Long straddle at minimum cost (5 marks)
iii. Short strangle (5 marks)
2. Aminah has decided to buy 20 lots of ABC’s September RM11.50 Put for 80 sen today.The
daily closing prices are given as follow:
I. Illustrate the payoff diagram with proper labels (5 marks)
Day 1
RM12.00
Day 2
RM11.80
Day 3
RM12.10
Day 4
RM11.60
Day 5
RM11.20
Day 6
RM11.00
II.
Compute the profit or loss of the put option when ABC’s stock is closed at RM10.80
(5 marks)
III.
Identify whether she should exercise the option as per result in (II) (2 marks)
3. Provided below is the information from BMDB
Option and expiry
Call September 2017
Call September 2017
Put September 2017
Put September 2017
Strike Price
950
970
950
970
May 2017
Premium
30
25
25
30
Sketch the pay-off diagram and determine the breakeven, maximum profit and loss for
the following strategies. (15 marks)
I. Long Put
II. Short straddle
III. Long Strangle
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
4. In September, Aiman bought 20 lots of WXYZ Corp Put for RM0.95 at the strike price of
RM8. At th same time, the stock was selling for RM8.55. The option would expire in
October. In mid October, the stock price rose by RM0.55. Due to global crisis, the stock price
tumbles down significantly by 50% below the exercise price in late October. Oct 2016
I.
II.
III.
State the name of the above strategy when entering the trading (1 mark)
Construct the pay-off diagram and label the relevant prices. (7 marks)
Quantitatively determine whether he should exercise the option in late October. (3
marks)
IV.
Calculate the profit or loss if the stock price rises by 50% in late October instead of
falling ( 2 marks)
Interpret whether he should exercise the option according to the answer in
(IV) (2 marks).
V.
FO_by_IM
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FUTURES AND OPTIONS (FIN379)
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