Module 14
Futures and Options
Additional Reading Materials
on USD Crude Palm Oil Futures (FUPO)
Copyright 2009
Securities Industry Development Corporation
3, Persiaran Bukit Kiara
Bukit Kiara, 50490 Kuala Lumpur
(This document consists of 22 pages including the cover page)
Additional Reading Material
USD Crude Palm Oil Futures (FUPO)
Commodity Futures – USD Crude Palm Oil Futures (FUPO)
Contents
Page
Topic Objectives
1
Outlines:
1.0 Introduction
2
2.0 The
2.1
2.2
2.3
futures contracts
Contract specifications for FUPO
Trading with palm oil futures
Users and uses of commodity futures
3.0 Trading Strategies with FUPO
3.1 Hedging with palm oil futures
3.1.1 Position hedge
3.1.2 Anticipatory hedge
4
8
3.2 Speculating with palm oil futures
3.2.1 Outright position
3.2.2 Spread trading strategies
3.3 Arbitraging with palm oil futures
3.3.1 No arbitrage pricing model
3.3.2 Cash-and-carry arbitrage
3.3.3 Reverse cash-and-carry arbitrage
4.0 Risks involved in trading FUPO contracts
4.1 Commodity Price Risk
4.2 Trading Risk
4.3 Foreign Currency Risk
4.4 Liquidity Risk
17
5.0 Comparative analysis between FUPO and Ringgit (MYR)denominated
palm oil futures contracts(FCPO)
18
6.0 Summary
6.1 Key Terms
6.2 Review Questions & Answers
19
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Additional Reading Material
USD Crude Palm Oil Futures (FUPO)
Topic Objectives
At the end of this topic, you should be able to:




Describe the features of the underlying instrument of the US Dollar denominated
crude palm oil futures (FUPO) contract
State the contract specifications for crude palm oil futures contract
Describe the trading mechanism and strategies for trading FUPO contracts
Construct a buying and selling hedge using crude palm oil futures
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Additional Reading Material
USD Crude Palm Oil Futures (FUPO)
1.0
Introduction
FUPO is a USD denominated palm oil futures contract, launched by Bursa Malaysia
Derivatives Bhd. in September 2008. It is considered as a commodity derivatives
instrument complementing the Ringgit denominated Crude Palm Oil Futures
contract (FCPO), which has been trading since 1980.
The underlying instrument for this commodity futures contract is Crude Palm Oil
(CPO). As an edible oil, its worldwide demand is only second to soybean oil and it is
also the most widely traded edible oil in the world. It has a balanced ratio of
unsaturated and saturated fatty acids, making it an edible oil that is suitable for
use in a variety of food application.
Malaysia currently accounts for 41 % of world palm oil production in 2007 and 46%
of world exports, which is equivalent to 11.5% and 26% of the world's total
production and exports of oils and fats respectively (source: Malaysian Palm Oil
Board). Therefore, as the major producer and exporter of palm oil and palm oil
products, Malaysia has an important role to play in fulfilling the growing need for
oils and fats.
Palm Oil Exports To Major Countries
Country
China
European Union
Pakistan
India
Japan
USA
TOTAL
Jan-08
Jan-09
Change
(Volume)
Change
(%)
Jan - Dec
2008
257,914
108,444
121,428
37,738
44,183
73,158
154,267
142,246
223,935
203,049
52,924
88,705
-103,647
33,802
102,507
165,311
8,741
15,547
-40.2
31.2
84.4
438
19.8
21.3
3,794,494
2,052,769
1,257,396
970,734
547,468
1,047,668
642,865
865,126
222,261
34.6 9,670,529
Source: Malaysian Palm Oil Board
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USD Crude Palm Oil Futures (FUPO)
The existing Ringgit denominated Crude Palm Oil Future contract (FCPO) has been
very successful since its introduction to the market and it has become the global
pricing benchmark for palm oil. With the launching of FUPO, together, both
products will help to consolidate Malaysia’s position as the leading price discovery
centre for palm oil.
The main driving factor for introducing FUPO is to offer an avenue for funds that
were previously unwilling to trade in the FCPO due to currency risk exposure. Being
the first US dollar-denominated crude palm oil futures contract in the region, it
also enables foreign buyers and importers to hedge their exposure to CPO price
fluctuations in USD instead of Ringgit. With FUPO and FCPO trading side by side, it
provides arbitrage opportunities to traders as a result of currency movement in
between the Ringgit and USD contracts.
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USD Crude Palm Oil Futures (FUPO)
2.0
The Futures Contracts
FUPO is a USD-denominated futures contract listed on Bursa Malaysia Derivatives
Berhad. Each contract is equivalent to 25 metric tons of crude palm oil which will
be cash settled upon maturity, against a final settlement price that is based on
FCPO price, that is the globally accepted benchmark price for CPO. The exchange
rate of USD/MYR will be taken from Bank Negara Malayisa as the conversion rate for
the calculation of the final settlement value. Stated in section 2.1 are the detailed
contract specifications for FUPO.
2.1
Contract specifications for FUPO
Contract Code
Underlying Instrument
Contract Size
Minimum Price
Fluctuation
Settlement
Methodology
Daily Price Limits
FUPO
Crude Palm Oil
25 metric tons
USD0.25 per metric ton
Cash Settled
A +/- 10% limit from the Settlement Prices of the
preceding trading day will apply for all contract months,
except for the spot month. When at least 3 non-spot
month contracts are trading at the 10% limit, a 10 minute
Cooling Off period will apply for all quoted months (except
spot month as there are no price limits for spot month
contract) during which trading shall only take place within
the 10% Limit. Following the Cooling Off period, all quoted
months shall be interrupted for 5 minutes, after which the
price limit will be expanded to +/-15%.
The 10% price limit will apply for the rest of the 1st trading
session if the price limit is triggered less than 30 minutes
before the end of session, and the price limit will be
expanded to 15% for the 2nd trading session.
Contract Months
Trading Hours
Speculative
Limits
Position
Final Trading Day and
If the 10% limit is triggered less than 30 minutes before the
end of the 2nd trading session, the 10% limit will apply for
the rest of the trading day.
Spot month and the next 5 succeeding months, and
thereafter, alternate months up to 24 months ahead
First trading session : Malaysian Time: 10:30 a.m. to 12:30
p.m.
Second trading session : Malaysian Time: 3:00 p.m. to 6:00
p.m.
 500 contracts net long or net short for the spot
month
 5,000 contracts for any single contract month
except for the spot month
 8,000 contracts for all contract months combined
Contract expires at noon on the 15th day of the spot
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USD Crude Palm Oil Futures (FUPO)
Maturity Date
Final Settlement
Final Settlement Price
month, or if the 15th is a nonmarket day, the preceding
Business Day.
Cash settlement based on the Final Settlement Value.
The average price of the Daily Spot Month Settlement Price
of the FCPO on the last 5 Business Days prior to the
expiration including the Final Trading Day. The mid
exchange rate of USD/MYR as at 6.00pm on each of the 4
Business Days prior to the Final Trading Day taken from
Bank Negara Malaysia shall be used as the conversion price
for the calculation of FCPO Daily Spot Month Settlement
Value (Mid price USD/MYR multiplied by the Daily Spot
Month Settlement Price of FCPO).
The mid Exchange rate of USD/MYR as at noon will be used
for calculation of Daily Spot Month Settlement Price for
the Final Trading Day.
The FUPO Final Settlement Value shall be the average of
the converted FCPO Daily Spot Month Settlement Prices
rounded to the nearest 25 cents.
2.2
Trading with palm oil futures
To start trading with FUPO, an investor will first need to open a futures trading
account with a futures broker and deposit cash or collateral with the broker.
However, a USD bank account is not required for trading. The futures broker will
be able to act as an agent to licensed onshore banks, to quote exchange rates for
the conversion of the MYR deposit to USD to facilitate the settlement in USD.
For Malaysian resident without domestic MYR credit facilities (borrowings in MYR),
there will be no restrictions on funds flow. However, for those with domestic MYR
credit facilities, conversion of MYR to USD is capped at MYR1 million per year for
individuals and MYR50 million for corporate group if the investor choose to convert
MYR to trade in USD. There will be no restrictions if trading is done with existing
foreign currency funds. Those who carry out the transactions in MYR will be
excluded from the above mentioned restrictions (Figure 1 is a flow chart of the
exchange control for resident). As for foreigners, there will be no exchange
controls applicable for the trading of FUPO.
The trading of FUPO will take place on Bursa Malaysia Derivatives Berhad and
prices are disseminated real-time through Bursa Malaysia and a number of price
reporting agencies
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2.3
Users and uses of commodity futures
The main feature of FUPO that differentiates it from FCPO and other regional
commodity futures contracts is that it is denominated in USD. Therefore, all parties
that are subject to USD currency risk can use it as a currency risk management tool
to lock in their exposure in USD and thus eliminating the uncertainty due to
USD/MYR currency fluctuation.
Major group of users of commodity futures are:



Corporate users, such as plantation companies, edible oil manufactures,
bio-fuel producers and users, shipping and freight companies, will hedge to
minimize their risk exposure in the underlying commodity markets.
Institutional investors, such as fund managers and trading houses will use
commodity futures to manage and diversify their investment portfolios.
Individual investors or traders who trade for profit. They are an important
group of liquidity providers.
The commodity futures are mainly used as a tool to:




hedge against a price increase or decline in palm oil or other close
substitutes, such as soya or rapeseed oil in near future for a buyer or seller
use as an alternative for holding physical palm oil until it is required or
available in the physical market
trade in a directional market movement by buying low/selling high in a
bullish market or vice versa in a bearish market
take advantage of any temporary mispricing conditions between the
underlying physical market and the commodity futures market. The
availability of both FUPO and FCPO also provide the arbitrage opportunities
from price discrepancies between these two contracts.
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Figure 1: The exchange control for Resident
Resident
Resident with Domestic MYR Credit Facilities
Resident without Domestic MYR Credit Facilities
Pay in USD; Receive in USD/MYR or
Pay in MYR; Receive in USD
Pay in USD; Receive in USD/MYR or
Pay in MYR; Receive in USD
Pay in MYR;
Receive in MYR
Conversion of MYR is capped (per year) at:
. MYR 1 million for individuals
. MYR 50 million for corporate group
Pay in MYR;
Receive in MYR
No restrictions on funds flow
Trading Participants
USD CPO Futures
Source: Bursa Malaysia Derivatives Berhad.
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3.0
Trading Strategies with FUPO
3.1
Hedging with palm oil futures
Hedging is used by individuals and corporations that make purchases and sales in
the commodity futures market for the purpose of establishing a known price level
in advance, for something they later intend to buy or sell in the physical
commodity market. In this way they attempt to protect themselves against the risk
of an unfavourable price change in the interim.
3.1.1 Position hedge
A position hedge is to take a futures position that is equal and opposite to a
position held in the physical market in order to mitigate the risk of an
adverse move in prices of the underlying commodity.
For example, a producer of crude palm oil has the risk that the cash price
will decrease before the palm oil is being harvested and can be sold to
overseas market. Therefore, he can choose to sell FUPO, which is a USDdenominated palm oil futures contract to mitigate this risk.
Subsequently, when the crude palm oil is being harvested, if the cash palm
oil price in fact declines, the futures price will have decreased as well since
both the futures and the underlying commodity are highly correlated. Then,
the producer can buy back (or offset) the futures contract at a price that is
less than the price he sold it for, generating a profit. This profit can then be
applied to the revenue he gets from selling the palm oil in the cash market,
thereby mitigating the cash price decrease.
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USD Crude Palm Oil Futures (FUPO)
For simplicity, the examples quoted below are excluding transaction costs.
Month
Cash Market
Current price = USD 563/metric ton
March
June
3.1.2
Futures Market
Sell 4 June FUPO contracts @
USD563/metric ton
Plantation owner expects to harvest
100 metric tons CPO for sale in near
future
Total futures value = 4 x 25 x 563
= USD 56,300
Current price = USD 550/metric ton
Current price = USD 550/metric ton
Sell 100 metric tons CPO = 100 x 550
= USD 55,000
Close the position by buying 4
June futures = 4 x 25 x 550
= 55,000
Net profit = USD 56,300 - 55,000
= USD 1,300
Adding profit from Futures
= USD 56,300
Effective price/metric ton
= 56,300/100
= USD 563/metric ton
Anticipatory hedge
Individuals and corporations can lock in the prices of the underlying
commodity that they intend to purchase or sell in the future by buying or
selling the commodity futures contract. In this way they attempt to protect
themselves against the risk of an unfavourable price change in the interim.
However, in doing so, they forego the potentials of making profit in the
event the prices of the underlying commodity go favourable, in exchange
for the elimination of the downside risk.
Example, an overseas refiner needs to purchase 250 metric tons of
processed palm oil to fulfil an order in 3 months time. He is anticipating
that the crude palm oil price is moving in an uptrend, but he does not want
to buy now due to logistical issues. The current CPO price in the physical
market is @ USD 563/metric ton and the futures price for May, which is 3
months’ time, is @ USD 565/metric ton.
Assuming when it’s time for the refiner to obtain the 250 metric ton of CPO
in the physical market in May, the CPO price in the cash market has reached
USD 570/metric ton. He can now close his position in the futures by selling
the 10 FUPO contracts and use the profit of USD 1,250 from the futures
contracts to offset the higher cost of buying the CPO in the physical market.
Therefore, his effective cost of CPO will end up at USD 565/metric ton
instead of USD570/metric ton.
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With the availability of FUPO, the refiner can now trade in USD and thus
avoiding the currency risk due to exchange rate fluctuation.
Month
Cash Market
Current price = USD 563/metric ton
Feb
May
Futures Market
Buy 10 May FUPO contracts @
USD565/metric ton
Oil refiner required 250 metric ton
in 3 months time
Total futures value = 10 x 25 x 565
= USD 141,250
Current price = USD 570/metric ton
Current price = USD 570/metric ton
Buy 250 metric tons CPO = 250 x 570
= USD 142,500
Close the position by selling 10
May futures = 10 x 25 x 570 = 142,500
Cost of buying after deducting profit
from futures = USD141,250
Net profit = USD 142,500 - 141,250
= USD 1,250
Effective price/metric ton
= USD141,250/250
= USD 565/metric ton
3.2
Speculating with palm oil futures
Speculating is basically the action of betting on where the market is heading based
on the speculators’ opinion. For example, if a speculator is of the view that the
price of the commodity futures is going on a down trend, he may short sell the
futures contract and wait for the price of the futures contract to decline, at which
point he will close his position by buying back the contract and receive a profit.
While hedgers buy or sell futures contracts to protect them from the adverse price
movement of the underlying commodity, speculators seek to profit from the
anticipated increase or decrease in the futures price. In doing so, they help to
provide the liquidity needed to facilitate hedging. However, speculators are facing
higher risks than hedgers.
3.2.1 Outright position
The commodities futures markets provide speculators with an easy
mechanism to speculate on the price of underlying commodities, without
the need of holding physical commodities. For example, if someone is
expecting the price of the crude palm oil to go in an uptrend in the near
future, he can seek to profit by buying futures contracts now and sell when
the futures price hit his target. However, if the price declines rather than
increases, the trade will result in a loss. Because of the leverage of a
futures position, the gain or loss may be greater than the initial margin
deposit.
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USD Crude Palm Oil Futures (FUPO)
For example, a trader starts his trading account with an initial margin of
$5,000 and buy 1 FUPO contract at the price of $1,000/metric ton. At the
end of each day, the broker will mark-to-market the contract that the
trader buy based on the settlement price determined by Bursa Derivatives
and the trading account will be credited for profit or debited for loss of the
day. If the balance in the account falls below the maintenance margin, then
a margin call will be made and the investor will be asked to either top up
the account or close his position. Assuming at the end of the 6th day, the
price reaches $1,050/metric ton and the trader decides to close his position
by selling off the contract. However, within that 6 day period, he had
topped up his margin account with an additional $2,500, thereby making his
total invested capital to be $7,500. His net profit for this investment will be
calculated as follows (refer to table below for more details):
Net profit
= (Selling price – buying price) X 25
= ($1,050 - $1,000) X 25
= $1,250
Net profit% = $1,250/$7,500
=16.67%
FUPO price change % = ($1,050 - $1,000)/$1,000
= 5%
From the above calculation, even though the value of the FUPO only
appreciates by 5% during that 6 days period, however, due to leveraging
effect, the net profit % that is obtained by the investor is 16.67%.
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USD Crude Palm Oil Futures (FUPO)
Day / Action
Day 1
Settlement
Price FUPO
Jun06 (USD)
Account
Balance
(USD)
Explanation
Margin required for each lot of
FUPO Jun06 contract :
You deposit $5,000 in
your trading account
5,000
Initial Margin: $5,000
Maintenance Margin: $ 4,000
5,000
Day 2
You Buy 1 FUPO Jun06
contract @ $1000
1,020
+
500
= 5,500
5,500
Day 3
Price of FUPO Jun06
drops
1,010
-
250
= 5,250
A profit of $500 is credited to
the account.
($1020-$1000) X 25 = $500
A loss of $250 is debited to the
account.
($1010-$1020) X 25 = -$250
A further loss of $2750 is debited
to the account.
($900-$1,010) X 25 = -$2,750
- 2,750
A margin call is issued as the
account balance is now less than
the maintenance margin
requirement of $4,000
= 2,500
You have the following choices:
5,250
Day 4
Price of FUPO Jun06
drops drastically
900
(1) Top up the margin account
to the initial margin level of
$5,000; or
(2) Close out your open position
Day 5
You chose to top up your
account and maintain
your positions.
2,500
1,000
Price of FUPO Jun06
recovers
+ 2,500
+ 2,500
= 7,500
You deposit $2,500 to restore
you minimum Initial margin level
at start of day
At the end of the trading day, a
profit of $2,500 is credited to
the account.
($1,000-$900) X 25 = $2,500
Day 6
Price of FUPO Jun06 rises
again. You decide to
close out your position by
selling all 1 FUPO Jun06
contract at $1,050
7,500
1,050
+ 1,250
= 8,750
A profit of $1,250 was credited
to the account.
($1,050-$1,000) X 25 = $1,250
Source: USD Crude Palm Oil Futures (FUPO), Bursa Malaysia Derivatives Bhd
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During a bear market, the speculators can also profit from the down market by
short selling the FUPO futures, and buying back when the price drops below a
certain target.
A trader starts his trading account with an initial margin of $5,000. He short sells 1
FUPO contract at $1,050/metric ton and buys it back to close his position after the
price has dropped to $1,000. His profit will be calculated as follows:
Net profit
=(Selling price – buying price) x 25
= ($1,050 - $1,000) x 25
= $1,250
Net profit% = $1,250/$5,000
=25%
FUPO price change % = ($1,050 - $1,000)/$1,000
= 5%
Action
Settlement
Price
FUPO
Jun06
(USD)
Account
Balance
(USD)
You deposit $5,000 in
your trading account
Sell 1 FUPO Jun06
contract @ $1,050
1,050
5,000
Buy 1 FUPO Jun06
contract to close the
1,000
5,000
+ 1,250
position
Explanation
= 6,250
Margin required for each lot of
FUPO Jun06 contract
Initial margin: $5,000
Maintenance margin: $4,000
A profit of $1,250 is credited to the
account.
($1,050 - $1,000) x 25 = $1,250
3.2.2 Spread trading strategies
Spread trading involves the purchase of one futures contract and the sale of
another futures contract concurrently in the hope of profiting from a price
divergence. As the profits or losses occur only as the result of a change in
the price difference, rather than a change in the overall level of futures
prices, spreads are usually considered as more conservative and less risky
compare to an outright long or short futures position.
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USD Crude Palm Oil Futures (FUPO)
For example, in November, the March FUPO price is presently $500/metric
ton and the May FUPO price is presently $510/metric ton, a difference of
$10. Based on the analysis of market conditions, the trader is of the opinion
that over the next few months, the price difference between the two
contracts will widen to become greater than $10. In order to profit from
this widening gap, he could sell the March futures contract (the lower
priced contract) and buy the May futures contract (the higher priced
contract).
Assume time and events prove him right and that, by February, the March
futures price has risen to $505 and May futures price is $525, thus resulting
in a difference of $20. By liquidating both contracts at this time, you may
realize a net gain of $10/metric ton. Since the size of each contract is 25
metric tons, the total gain is $250. ($10 x 25)
November
February
Gain/Loss
Sell March FUPO
Buy May FUPO
Spread
$500
$510
$10
Buy March FUPO
Sell May FUPO
Spread
$505
$525
$20
$5 loss
$15 gain
Had the spread (i.e. the price difference) narrowed by $10/metric ton
rather than widened by $10/metric ton, the transactions just illustrated
would have resulted in a loss of $250.
November
February
Gain/Loss
Sell March FUPO
Buy May FUPO
Spread
$500
$510
$10
Buy March FUPO
Sell May FUPO
Spread
$495
$495
0
$5 gain
$15 loss
Spread trading strategies can be carried out using two different months’
contract (intra-commodity spread) or between two different futures
contracts (inter-commodity spread), such as FUPO and FCPO to capitalize on
the temporary price difference.
Example: On Jan 2, March FUPO contract is trading at US$492.9/ton metric
while March FCPO contract is trading at RM 1711/ton metric (converted to
US$478.6 @ exchange rate of RM3.575/USD). The difference between these
two contracts is at US$14.3. A trader believes that the inter-commodity
spread between these two futures will continue to widen in the near future.
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Therefore, he could profit by purchasing the March FUPO contract and at
the time short selling the March FCPO contract.
On Jan 12, the prices of March FUPO and FCPO are at US$590 and RM1959
(converted to US$564.3 @ exchange rate of RM3.4715/USD) respectively.
The spread between these two contracts has widened to $25.7. The trader
will close his positions by selling the March FUPO and buying the March
FCPO. At this time, he has made a profit of $11.4/ton metric or
$285.5/contract (25 x $11.4).
Jan-02
Jan-12
Gain/Loss
3.3
Sell March FCPO
Buy March FUPO
Spread
$478.6
$492.9
$14.3
Buy March FCPO
Sell March FUPO
$564.3
$590.0
$85.7 loss
$97.1 gain
$25.7
Arbitraging with palm oil futures
Arbitraging with palm oil futures is the simultaneous purchase of the
physical palm oil commodity against the sale of a FUPO contract, or vice
versa, to lock in a minimum risk profit from unequal prices.
3.3.1 No arbitrage pricing model
The law of one price states that in a competitive market, if two
assets are equivalent from the point of view of risk and return, they
should sell at the same price. If the price of the same asset is
different in two markets, there will be arbitragers who will buy in
the market where the asset sells cheap and sell in the market where
it is costly until the prices in the two markets reach an equilibrium.
Hence, arbitrage helps to equalise prices and restore market
efficiency. Based on the no-arbitrage model, the fair price of palm
oil futures should be calculated as:
F = S [ 1 + (r x t/365) + (c x t/365)]
where:
F = futures price of the commodity
S = spot price of the commodity
r = annual risk-free interest rate (cost of financing)
t = Time till expiration
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c = annualized cost of storage (%)
3.3.2 Cash-and-carry arbitrage
An arbitrageur notices that FUPO futures seem overpriced. He can
cash in on this opportunity to earn riskless profits by using a cashand-carry arbitrage.
For example, crude palm oil in the physical market is trading at USD
550/metric ton. 2nd month FUPO contract is trading at USD
580/metric ton. Based on the no-arbitrage pricing model, with the
assumption that borrowing cost is at 6% and storage cost is at 5%,
the fair price is USD555/metric ton. Therefore, at USD580, the FUPO
contract seems to be overpriced.
F = USD550 [1 + (6% x 30/365) + (5% x 30/365)] = USD555
The trader could make riskless profit by entering into the following
set of transactions. Assume he buys 250 metric tons of CPO. He will
borrow the cost of buying of USD 137,500 (USD550 x 250) at an
interest rate of 6%. He then stores the physical commodity for 1
month at a storage cost of 5%. At the same time, he sells 10 2nd
month FUPO contracts @ USD580/metric ton.
After one month, the spot price for CPO is USD560/metric ton. He
sells the CPO in the physical market for USD140,000 and unwinds his
FUPO position by buying 10 FUPO contracts with a profit of USD5,000.
After paying off his loan + interest cost + storage cost, his riskless
profit is USD6,257 (refer calculation shown in the table below).
Month
May
Cash Market
Futures Market
Borrow USD 137,500 to buy 250 metric ton
CPO @ USD550 per metric ton (550 x 250)
Sell 10 FUPO contracts @ USD
580/metric ton
Borrowing cost @ 6% = USD678
(6% x 30/365 x 550 x 250)
Value = 580 X 25 X 10
= USD 145,000
Store for 1 month,
storage cost @ 5% = USD565
(5% x 30/365 x 550 x 250)
Sell 250 metric ton in cash market @
USD560
June futures now at USD560 Unwind
the position by buying 10 FUPO
contracts
Value = USD560 x 250
= USD 140,000
Value = USD140,000
Profit from FUPO = USD5,000
June
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Additional Reading Material
USD Crude Palm Oil Futures (FUPO)
Cash on hand ($140,000 + $5,000)
Less: Loan
Borrowing Cost
Storage Cost
$145,000
$137,000
$678
$565
$6,757
When does it make sense to enter into an arbitrage? If the cost of
borrowing funds to buy the commodity and the cost of storage is less
than the arbitrage profit, it makes sense to arbitrage. However, in
the real world, in order to exploit an arbitrage opportunity, it
involves simultaneous trading on the spot and futures market.
Therefore, one has to build the transactions costs into the arbitrage
strategy.
3.3.3 Reverse cash-and-carry arbitrage
On the other hand, if the FUPO seems to be underpriced relative to
the spot market, then a reverse cash-and-carry arbitrage is made
possible by buying the FUPO contracts and at the same time selling
in spot market. It is the exact reverse of a cash-and-carry arbitrage.
However, in real life, this type of arbitrage is hardly practised on
CPO due to the perishable nature of the CPO and difficulties in
borrowing in cash market.
4.0
Risks involved in trading FUPO contracts
Trading in FUPO contract, as in any commodity futures trading, involves a high
degree of leverage, which allows the possibilities of large returns and at the same
time, large losses. Due to the high degree of risk involved in high leverage, anyone
involved in FUPO trading should be aware of the risks inherent in it.
4.1
Commodity Price Risk
Commodity prices are determined by the supply and demand conditions in
the market, thus, sensitive to business cycle. In addition, the prices can
also be volatile as they are affected by many other unpredictable factors,
such as weather, change in government policies and financial or economic
distress.
4.2
Trading Risk
As trading in FUPO involves leveraged trading, it will magnify the effect of a
given change in price, which will result in significant losses if the market
moves against the trader’s expectation. As the amount of initial margin is
small relative to the nominal value of the futures contract, a relatively
small market movement will have a proportionately larger impact on the
funds that the trader has in his trading account.
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Additional Reading Material
USD Crude Palm Oil Futures (FUPO)
If the margin levels are increased or when there are margin calls, the trader
will be called upon to pay substantial additional funds on short notices in
order to maintain his position. If he fails to comply with a request for
additional funds within the time prescribed, he faces the risk of forced
liquidation at a loss and will be liable for any resulting deficit in his trading
account.
5.0
4.3
Foreign Currency Risk
As FUPO is denominated in USD, for those who trade in MYR or other
currencies, the profit or loss in transactions will be subjected to
fluctuations in currency rates. This is especially significant at times when
the currency is experiencing high volatility.
4.4
Liquidity Risk
FUPO is a relatively new futures product in the market. In order to facilitate
a liquid market so that futures participant can freely buy and sell contracts,
market makers play an important role in providing the liquidity needed.
Currently, FUPO is lacking of liquidity in the market as it is not being
actively traded yet.
Comparative analysis between FUPO and Ringgit (MYR) denominated palm oil
futures contracts (FCPO)
Contract Specification
FUPO
FCPO
Final Settlement
methodology
Cash settled upon expiry
Currency denomination
USD denominated
MYR denominated
Exposed to USD currency risk if
required to convert to MYR
Exposed to MYR currency risk if
required to convert to other
currencies
Final settlement value shall be the
average price of the daily spot
month settlement price of the
FCPO on the last 5 business days
Final settlement value based on
the daily sport month settlement
price of FCPO
Final Settlement value
Physical delivered upon expiry
Need to pay attention to the
contract grade and delivery points
Conversion to USD is based on the
mid exchange rate of USD/MYR at
6.00pm on each of the 4 Business
Day prior to the Final Trading Day
and at noon on the Final Trading
Day.
No conversion required. Prices are
stated in MYR
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Additional Reading Material
USD Crude Palm Oil Futures (FUPO)
6.0
Summary
In this topic, we have described the unique features of the US Dollar denominated
crude palm oil futures (FUPO) contract and explore the various uses of FUPO,
including hedging, speculating and arbitraging, and the risks involved in trading
FUPO. In addition, we have also included a comparative analysis between FUPO and
FCPO.
6.1
Key Terms
Position hedge
Anticipatory hedge
Outright position
Cash-and-carry arbitrage
Reverse cash-and-carry arbitrage
Spread trading
Glossary
Position hedge: to take a futures position that is opposite to the current
physical position held
Outright position: a position in a futures contract that is not offset
6.2
Review Questions
Question 1
Based on the contract specifications for FUPO, determine whether the
following statements are true or false:
a) The underlying instrument for FUPO is crude palm oil.
b) The settlement methodology for FUPO is physical
settlement.
c) The contract size for FUPO is 20 metric ton per contract.
d) The speculative position limit is 500 contracts net long
or net short for the spot month.
e) The FUPO is USD-denominated
Answer:
a) True
b) False – it is cash settlement
c) False – it is 25 metric ton per contract
d) True
e) True
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Additional Reading Material
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Question 2
A trader buys 5 FUPO contracts at USD576/metric ton. A week later the
price of the FUPO contract rises to USD 580/metric ton and he closes his
position. How much profit/loss has he made on his position?
Answer:
Profit/metric ton = sell price – buy price = USD580 – USD576 = USD4/metric
ton
Total profit $ = USD4 x 25 x 5 = USD500
Question 3
A trader short sells 10 FUPO contracts at USD575/metric ton. 4 days later
the price of the FUPO contract drops to USD565/metric ton and he closes
his position. How much profit/loss has he made on his position?
Answer:
Profit/metric ton = sell price – buy price = USD575 – USD565 = USD10/metric
ton
Total profit $ = USD10 x 25 x 10 = USD2,500
Question 4
In May, a purchasing officer for an US oil refinery company plans to
purchase 1000 metric tons of crude palm oil in 3 months time. He intends to
lock in the purchase price now.
The current CPO price in the cash market is @ USD 560/metric ton and the
futures price for Aug, is @ USD 580/metric ton.
a) Should he buy or sell FUPO contracts to lock in his purchase price?
b) How many FUPO contracts does he need in order to be fully hedged?
c) Assuming when it’s time for the refiner to obtain the 1000 metric ton of
CPO in the physical market in Aug, the CPO price in the cash market is
USD 550/metric ton and the Aug FUPO contract price is USD 550/metric
ton.
i) What is the profit/loss of the FUPO position when it is closed?
ii) What is the effective price that the company has paid for the 1000
metric tons of crude palm oil?
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Additional Reading Material
USD Crude Palm Oil Futures (FUPO)
Answer:
a) The purchasing officer should do an anticipatory hedge to lock in the CPO
purchase price and buy FUPO contracts, which are USD denominated, as his
dealings are in USD dollar.
b) He should buy 1000/25 = 40 FUPO contracts to fully hedge.
c) (i) FUPO loss/metric ton = USD550 – USD580 = -USD30/metric ton
Total loss in the FUPO position = -USD30 x 25 x 40 = -USD30,000
(ii) Buy 1000 metric ton of CPO in cash market at USD550/metric ton.
Cost of purchase = 1000 x 550 = USD550,000
Net cost/metric ton after considering the loss from FUPO
= USD(550,000 + 30,000)/1000
= USD580/metric ton
The effective price of the purchase is the same as the price that the
purchasing officer has locked in using the FUPO hedge.
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