CHAPTER 7
FUTURES DERIVATIVES
1
Learning Objectives
 Describe a derivative
 Describe the history of derivative
 Describe the development of derivative in Malaysia
 Explain the difference between forward and futures contract
 Explain terms convergence, margins and marking to market
and basis risk
 Explain the terms hedging, speculating and arbitraging with
futures
 Describe the contract specification of FCPO and FKLI
 Know how to hedge, speculate and arbitrage using FCPO
and FKLI
 Explain and understand the term single stock futures
2
Chapter Outline
•
•
•
•
Introduction to Derivatives
Forward and Futures Contracts
The Key Elements of in Futures Trading
Hedging, Speculating and Arbitraging with
Futures Contract
• The Crude Palm Oil (FCPO) and KLCI (FKLI)
futures
• Single Stock Futures (SSF)
3
What is a derivative?
 The word ‘derivative’ implies they derive their value from
something.
 It originates from mathematics and it is a variable that derives
from another variable.
 Derivatives on its own have little value but when it derives from
some other asset, known as the underlying, hence, it has its
value.
 The underlying can be share prices, prices of commodity,
indices and interest rates.
 For example, a derivative of Air Asia shares will derive its value
from share price of Air Asia (underlying).
 Similarly, a derivative contract on Crude Palm Oil depends on
the price of palm oil and the derivative of Kuala Lumpur
Composite Index (KLCI) will depend on the movement of the
KLCI.
4
Why do derivative markets exist?
• Largely to facilitate hedging.
• The derivative markets are largely insurance
markets.
• Firms, like individuals are risk averse and
would like to protect themselves against three
main types of risk that businesses face: PRICE
RISK, CURRENCY RISK and INTEREST RATE
RISK.
5
SPOT MARKET vs FORWARD/FUTURES
MARKETS
• In the spot (cash) market, buyers and sellers
agree on Price (P) and Quantity (Q) for
immediate delivery (or within a few days).
• Example: Proton buys 1 million Japanese Yen
in the spot market for currency, or it buys 100
tons of steel in the cash market for steel. MAS
buys 500,000 gallons of gasoline in the spot
market.
6
FORWARD CONTRACT
• Private contracts between two parties (buyer
and seller) for delivery sometime in the future
(one month, one year).
• Not marketable securities and there is no
secondary market.
• E.g. like the difference between a bank loan
(not marketable) and a bond (marketable).
7
Mechanics of Forward Contracts: An illustration
• Assume there are 2 parties – a cocoa farmer
who has planted cocoa on his farm and is
expecting to harvest the cocoa in 6 months
and a confectioner who produces chocolate
using cocoa powder.
• Assume further that the confectioner has in his
inventory, sufficient cocoa to last him for the
next 6 months, but would have to replenish his
stock at the end of the sixth month. Clearly,
both parties here are exposed to risk, in this
case price risk.
• The cocoa farmer faces the risk that the spot price of
cocoa could fall between now and 6 months from
now, when he completes his harvest. Such a fall will
obviously reduce his revenue and profits. Infact, if
the fall in spot price is sharp enough, he could even
face outright losses.
• The confectioner faces similar risk but in the
opposite direction. The spot price of coca could
increase between now and 6 months from now
when he needs to replenish his inventory. Any
increase in prices will increase his costs and reduce
his profits.
• Since both parties face price-risk and neither party
can tell which way prices would go, it would be in
their interest to go into an arrangement that could
protect them from this price-risk. Such an
arrangement would be the forward contract. Under
the forward contract, the farmer would agree to
deliver and the confectioner to take delivery of
cocoa of an agreed quantity on a mutually
agreeable date and at a price determined now – i.e.
at the time of initiation of contract.
Step 1 (at initiation of contract; day = 0)
Farmer
(Short position)
negotiate
Confection (Long
Position)
Agree on :
Price, quantity, quality,
maturity delivery location
etc.
Step 2 (on maturity date; day = 180)
Farmer
(Short position)
Cocoa
Confection (Long
Position)
Money
The long position agrees to take delivery (buy) of the underlying asset while the
short position agrees to make delivery (sell).
FORWARD CONTRACTS – EXAMPLE 1
• Giant Supermarket enters into a forward contract in May
to purchase rice at harvest time in October, at a
guaranteed price, from various rice farmers for their
entire crop.
• Advantage: buyer (company) and seller (farmer) gave a
guaranteed price. They are now protected from price
swings in rice.
• They have eliminated price risk completely by hedging
their position, locking in a price with a forward contract.
12
FORWARD CONTRACTS – EXAMPLE 2
• Toyota Motors enters into a contract for
British pounds with Bank One, to either buy
pounds or sell pounds, in six months at a
guaranteed exchange rate. By locking in,
Toyota Motors has hedged currency risk.
13
Advantages/Disadvantages of
Forward Contract
• Advantage: They are very flexible and can be customized to the
needs of the parties.
• Disadvantages:
– There is no liquid market for forward contracts, no secondary
market.
– Problem in price fixing. The party who has better negotiating
power may dictate an unfair price.
– High default risk. One party may default (not fulfilling the
future obligation agreed upon earlier), resulting in losses for
the other party. This risk is known as counterparty risk.
– Requires actual delivery to complete the contract..
14
FUTURES CONTRACTS
• Are the same in principle as a forward
contract, where two parties (buyer and seller)
agree to trade/exchange something (rice,
corn, oil, T-bills, Yen) in the future (one week,
one month, one year), but they agree on P
and Q now, for future delivery, using a futures
contract from a futures exchange – an
organized market for trading futures
contracts.
15
What is a futures contract?
• exchange-traded form of forward contract
• Basically to overcome 3 problems of forward contract
– (1) multiple coincidence needs,
– (2) unfair forward price and
– (3) counterparty risk.
• Because they are exchange-traded, the contracts are
standardised.
• Except for price the standardised contract would have
specified the quantity (or the contract size), quality (or
the grade) of the underlying asset, delivery date (or the
expiry date) and location of delivery.
16
Multiple Coincidence of Needs
• At least three things must match before the two
parties in a forward contract can even begin to
negotiate prices.
(i) asset match
(ii) maturity match
(iii) quantity match
• There could be others such as delivery location etc.
The result is that there could be substantial “search
costs” involved. One party will have to search out the
other thereby incurring costs in terms of time,
advertisement etc.
Potential for Price Squeeze/Unfair Price
• In a forward contract, the forward price is arrived at
through negotiation.
• The problem with negotiation is that, bargaining
position matters. If one party is in a weak bargaining
position, he could be squeezed by the other.
• However, if there is only one confectioner (potential
buyer of cocoa) in the district but several cocoa
farmers, the long position has the bargaining power
and could dictate on price.
• In such a situation, even if the cocoa farmer
feels the price offered may not be fair, he may
have little choice but accept the price. This
would be particularly so, if the product is
perishable and could spoil shortly after
harvest. The short position does not have
much of an option to wait and see if he could
fetch a better price post harvest.
Counterparty / Default Risk
• Counterparty risk or default risk, refers to the
possibility that one of the parties to the transaction
could default. Such default could happen not so
much because the party is “dishonest” but rather
due to the incentive to default given changes in the
spot price.
• However, if spot prices subsequently begin to fall,
the long position (confectioner) begins to hurt since
he has agreed to forward price based on the higher
previous spot price.
• The opposite is true if spot prices begin to rise after
the forward contract is negotiated. Now, the short
position, the farmer, begins to hurt since he would
feel that his cocoa could now be sold at higher
prices. He would regret having locked himself into
the ‘low’ forward price.
• We assume that the two parties had agreed on a
forward price of RM100 per ton. We examine what
will happen if say, the spot price on maturity day is
at RM70 per ton or RM120 per ton.
Advantages of futures contracts over
forward contracts
• Liquid market, lots of buyers and sellers at organized exchanges
all over the world.
• Active secondary market. Contract may trade hands many times
before expiration.
• Minimal risk. The futures exchange requires an initial margin to
open a position and they enforce daily settlement of all gains and
losses to avoid default. There is maximum price movement,
called daily limit, to minimize large losses. For example, daily
price limit for palm oil futures is 10% above or below the
settlement price of the preceding business day, trading stops for
the day.
22
Advantages of futures contracts over
forward contracts
• The counterparty risk is reduced through a clearing house which
take responsibility for ensuring the contract is brought through
without any parties defaulting in the transaction.
• Cash settlement for most futures contracts, instead of settlement
in the actual commodity.
• You can close your account anytime by taking an offsetting
position. If your original position is to buy (go long) a futures
contract, you can subsequently sell (go short) to close out your
position, and vice versa. You can cash out without having to make
or receive delivery.
23
Disadvantages of futures contracts
over forward contracts
• Less flexible since futures contracts are for fixed, standard
amounts, e.g. palm oil futures contracts are for 25 metric
tons per contract.
• Expiration dates are fixed: E.g. Jan, March, September and
December. (only few delivery per year.
• The location for delivery are fixed (Port Kelang,
Penang/Butterworth and Pasir Gudang (Johor)
24
Examples of futures contracts traded in
Bursa Malaysia Derivatives Bhd
• Stock Index Futures
– KLCI (FKLI) Futures
• Single Stock Futures (SSFs)
• Interest Rate Futures
– 3 Month Kuala Lumpur Interbank Offered Rate interest rate (FKB3)
• Bond Futures
– 3-Year Malaysian Government Securities (FMG3) Futures
– 5-Year Malaysian Government Securities (FMG5) Futures
– 10-Year Malaysian Government Securities (FMGA) Futures
• Agriculture Futures
– Crude Palm Oil (FCPO) Futures
– Crude Palm Kernel Oil (FPKO) Futures
– USD Crude Palm Oil (FUPO) Futures
25
The Key Elements of Futures Trading
•
•
•
•
•
Convergence of Futures and Cash Prices
Basis and Basis Risk
Margins and Marking to Market
Types of orders
The Clearing House
26
Price Convergence
• The futures price of a contract and the cash price (spot
price of the underlying) of the same commodity tend to
converge, i.e. they will come together as the delivery
month of the futures contract approaches. On maturity
date, the futures price must equal spot price.
• When futures price > spot price = contango.
• When futures price < spot price = backwardation.
• Determined by market forces (ss and dd)
27
The Convergence Property
• The convergence property states that the price of a
futures contract on the day of its maturity must
equal the spot price of the underlying on that day.
• The logic for this is that, on its maturity day, a
futures contract is essentially a spot asset.
• The Spot Price and the Future Price must be equal
otherwise there would be a riskless arbitrage
opportunity. One could even argue that the
existence of such arbitrage opportunity would
ensure convergence.
Spot-Futures Convergence at Maturity
Spot/Futures Price
Futures
Spot
t
Maturity day
Basis and Basis Risk
• Basis is the difference between cash price (or
spot price), S and Futures price, F.
• It reduces to zero at it approaches maturity of
the futures contract.
• In a perfect hedge, the gains or losses in the
futures contract exactly offset the losses or
gains of the underlying asset being hedged.
• If do not perfectly cancel each other out, it is
called basis risk. Due to mismatches of quality
(grade), location, maturity, qty.
30
Basis and Basis Risk
• The difference or spread between the futures and
spot prices is often known as the basis. The basis
should equal the net carrying cost.
• The basis narrows over time to reach zero at
maturity. Prior to maturity however, the basis would
be positive or occasionally negative.
Basis
 Ft ,T  S o
• Basis risk can be thought of as tracking error.
Basis risk would be present whenever there is
any of these three mismatches:
(i) Asset mismatch
(ii) Maturity mismatch and
(iii) Quantity (or contract size) mismatch.
Margins and Marking to Market
• Example:
Consider an investor, contacts his broker on Tuesday, 2nd of
June to buy two December crude palm oil futures contracts
at Bursa Malaysia Derivative Berhad. One futures contract
equivalent to 25 metric tons. Current market price is
RM2,000 per ton.
Therefore, the investor is contracted to buy 50 metric tons
at this price. The total value of this transaction:
= 2 contracts x 25 metric tons x RM2,000
= RM100,000
33
Margins and Marking to Market
• The broker requires the investor to deposit some money
in a margin account (initial margin). Assume that the
initial deposit is RM10,000 per contract = Initial Margin =
RM20,000.
• At the end of each day, the margin account is adjusted to
reflect the investor’s gain or loss.
• This is the additional margin payments that would have to
be paid and is called the variation / maintenance margin.
• This practice is referred to as “marking to market” or
(marked to market).
34
Margins and Marking to Market
• Assume that at the end of the day, the palm oil futures price closes at
RM1,850 per ton. This implies that the investor has made a loss = 2
contract x 25 metric tons x RM150 = RM7,500
• If the price for the following day closes at RM2,300 per ton, the
balance of the margin account will increase by:
2 x 25 x RM450 =
RM22,500
• Hence for the last two days, the margin balance has become RM35 000
= (RM20,000 – RM7,500 + RM22,500)
• The investor is entitled to withdraw any balance in the margin a/c in
excess of the initial margin (IM) = RM15 000
• To ensure that margin a/c does not become negative, a maintenance
margin is set (usually lower than IM).
• If the balance falls < maintenance margin, the investor will receive a
margin call. He is expected to top up the difference back to the initial
margin the following day.
35
DAY
Price
Variation gain/loss
Balance
0
2000
Pay margin 20 000
20 000
1
1850
(7500)
12 500
2
2300
450 x 2 x 25 = 22500
35 000
36
The Clearing House
• Acts as intermediary in futures transactions.
• Guarantees the performance of the parties in
each transaction.
• To ensure none of the parties are hurt by the
defaulting party.
38
Crude Palm Oil (FCPO) Futures and
KLCI (FKLI) Futures
• The Underlying Instrument of FCPO and FKLI
• The Contract Specification FCPO – refer to
Table 7.1 page 192
• The Contract Specification FKLI – refer to
Table 7.3 page 196
39
Trading Practicalities
• Long – bought futures contract
– Contract to receive delivery/contract to buy
underlying asset
– eg: Long 2 August 2011 FCPO at RM1000/tonne
[ Engage in contact to receive delivery of 50 tonnes of
CPO in August 2011 at RM1000/tonne]
• Short – sell futures contract
– Contract to make delivery/contract to sell
underlying asset
– Short 2 Aug 2011 at RM1000/t
[ Engage in contract to deliver 50 tonnes of CPO in Aug
2011 at RM1000/t]
40
EXERCISE
• Long 3 Dec 2012 FCPO @RM1,200
• TODAY:
• A contract to buy 75 tonnes of CPO in Dec 2012 at
RM1,200
• At maturityDec 2012
• BUY 75 tonnes of CPO and pay RM1,200  Physical
settlement
• OR
• SELL 3 Dec 2012 FCPO at price of Dec 2012 FCPO traded in
Dec 2012.  cash settlement
41
EXERCISE
• Long August FKLI @ 1120
• Contract to buy KLCI in August @ 1120
• SETTLEMENT
– CASH Settlement
– Sell Aug FKLI @ price of AUG FKLI traded in Aug.
42
Forwards, Futures; Zero sum Game
• In a world of limited/finite resources, most financial
transactions, including all derivatives transactions are
zero-sum games; that is one party’s gain is at another
party’s expense.
if spot prices rise
Profit to Long = Spot price at Maturity – Original
Futures Price
(the short position’s implied loss equals this amount)
if spot prices fall
Profit to Short = Original Futures Price – Spot price at
Maturity.
(the long position’s implied loss equals this amount)
Types of Futures Markets Participants
• Hedgers
• Speculators
• Arbitrageurs
44
Hedgers
• Futures traders who have a personal or
business interest in the future commodity
prices, exchange rate or interest rate.
• E.g. importers/exporters, corporations buying
and selling in the future, farmers, portfolio
managers, firms expecting to borrow money
in the future, firms/investors expecting to
invest money in the future, etc.
45
Hedgers - Examples
• Farmers (sellers) and producers are worried about the
price of their product going down in the future. They can
use futures contract to lock in price now for future output
of oil, corn, wheat, sugar, steel, gold etc by going SHORT
on contracts for their product.
• Exporters (importers) receiving foreign currency (paying in
foreign currency) can hedge risk by going short (long) on
currency futures.
46
• Given the KLCI is 1050 and the value of a portfolio is RM3
million. If the portfolio manager wishes to hedge 80%
against a price decrease, how many contracts will the
portfolio manager have to trade? Does the trader buy or
sell?
• Suppose in February, a palm oil producer anticipates that
he will have 180 metric tonnes of crude palm oil ready for
sale in four months’ time. He would like to fix the price for
his produce. The current market price (February) of the
palm oil is about RM2,250 per metric tonne while the
June crude palm oil futures (FCPO)is currently trading at
RM2,265.
47
Types of Hedging




Hedging is taking a (1) future position in anticipation of a
later cash transaction or (2) taking a future position
opposite to the current physical position held.
The former type is known as anticipatory hedging and the
latter type is known as hedging the current market
position.
An example of anticipatory hedging is the palm oil
producer who intends to sell his palm oil in 2 months
could lock in the price by selling the futures contract
today.
An example of hedging current market position is the fund
manager with a portfolio of shares could hedge against a
fall in share prices by selling (taking a futures position
opposite to the current position of holding a portfolio of
shares) stock index futures contracts today.
48
Strategy
• Number of contracts
• Contract Month
• Action
49
Types of Hedging
• anticipatory hedging
– - Refer to Table 7.5 page 199
• hedging the current market position
50
An Anticipatory Hedge
• Often, producers may not have an immediate position in an
underlying asset but a potential position. That is, they
anticipate having a position in the underlying asset at a
future point.
• Assume that the farmer is expecting to produce 120 tons of
cocoa in 6 months and wishes to hedge his price-risk.
Suppose further that cocoa futures are maturing in 6
months from now and have a standard size of 10 tons per
contract. The current quoted price for 6 month cocoa is say
RM100 per ton or RM1,000 per contract. For simplicity,
assume that the confectioner also requires 120 tons in six
months
• Notice that the cocoa farmer in our example did not have an
immediate exposure. He is expecting to harvest cocoa in 6
months. Yet, he hedges the position today. This is what is
known as anticipatory hedge.
• Each party could do their hedging through the
futures market as follows. The farmer would call
his futures broker and short (sell) 12 cocoa futures
for 6 month delivery while the confectioner would
instruct his broker to long 12 such contracts.
• At this point both parties would be fully hedged
since in 6 months the confectioner knows he will
have to pay exactly (RM1,000 x 12) = RM12,000 for
the 120 tons of cocoa he needs while the farmer is
assured of RM12,000 as payment for his cocoa.
• Notice that neither party needs to know who
the counter party is. Yet, each party is
assured of delivery/payment because the
exchange (through its clearing house)
becomes the counter party to both the
farmer and confectioner.
• On registration of the trade, the
clearinghouse guarantees the transaction.
Assuming both parties hold their position to
maturity, the cocoa futures contract will be
settled on its maturity day (day 180) as
follows.
Settlement of A Futures Contract
Cocoa
Warehouse
receipt
Cocoa
Exchange
Designated
Warehouse
Warehouse
receipt
(1)
(2)
(5)
Cocoa
Farmer
(short)
(3) w. receipt
Payment
(4)
Exchange
(Clearinghouse)
(3) w. receipt
(6
)
Confectioner
(Long)
Payment
(4)
Numbers within brackets show the sequence of events
Example
• Suppose in Feb, a crude palm oil producer anticipates that
he will have 200 metric tons of crude palm oil ready for sale
in two months time. He would like to lock in the price of his
crude palm oil. The current mkt price (Feb) is RM1,250 per
metric ton. April crude palm oil futures is currently trading
at RM1,265.
• His exposure to risk = price may fall between now (Feb) and
the time of sale (April) = risk of price decline.
• Action: Sell futures (short position) of a specific number of
contracts at a certain point in future
• = 200 tons/25 = 8 contracts
• Contract Month: April
55
• Assume in April the price of crude palm oil in the spot
market has dropped to RM1,245/ton. So has the April
futures (price convergence).
• The producer sells the CPO in the spot market for
RM1,245 and also closes out the futures position by
buying (long position) 8 futures contracts at RM1,245.
56
Summary of the positions:
Cash Mkt
Futures Mkt
Position Today
Position at Maturity
Gains/Loss
Mkt price = RM1,250
Mkt price = RM1,245
Action: sells 200 tons at
RM1,245.
Total sales = 200 x RM1,245
= RM249,000
RM249,000
Close its position by buying
8 futures contract
@RM1,245.
Action: Long Futures
= 8 x 25 x RM1,245
= RM249,000
RM4,000
Total revenue
RM253,000
Effective price per metric
ton
RM1,265
RM253,000
57
200 tons
Mkt price = RM1,265
Action: short futures
= 8 contracts at RM1,265
Total value of futures
= 8 x 25 x RM1,265
= RM253,000
Example
• Suppose in May, a crude palm oil refiner receives an order for a
800 met tons of refined PO to be delivered in Sept. He would like
to lock in the price of his crude palm oil. The CPO futures for
delivery in Sept is trading at RM1,270.
• Current spot price = RM1,265 (lower than futures price).
However he does not have the available cash to buy now.
• His exposure to risk = price may increase in the future.
• Action: Buy futures (long position) of a specific number of
contracts at a certain point in future
• = 800 tons/25 = 32 CPO Sept futures contracts at RM1,270.
• (he needs to pay only the initial margin)
• This gives confidence to the oil refiner to quote the price to his
customers using known PO cost.
58
Example
• In Sept, he purchases the 800 met tons of CPO in the spot
market at RM1,278
• He closes out the futures position by selling (short
position) 32 futures contracts at the current mkt price of
RM1,278.
59
Summary of the positions:
Position Today
Cash Mkt
Position at Maturity
Mkt price = RM1,265
Mkt price = RM1,278
The refiner needs 800 met Action: buys 800 tons
tons of CPO in Sept.
at RM1,278.
Total costs:
= 800 x RM1,278
= RM1,022,400
Futures Mkt Mkt price = RM1,270
Action: buy futures
= 32 contracts at RM1,270
Total value of futures
= 32 x 25 x RM1,270
= (RM1,016,000)
Gains/Loss
(RM1,022,400)
Close its position by
selling 32 futures
contract @RM1,278.
Action: sell Futures
= 32 x 25 x RM1,278
= RM1,022,400
RM6,400 (Pft)
Net costs
(RM1,016,000)
Effective price per
metric ton
RM1,270
(RM1,016,000)
800 tons
60
SPECULATORS
• Have no personal or business interest in the commodity or
currency. They are trading futures contracts as a purely
speculative investment or gamble.
• For example, an investor could take a position on a palm oil
futures contract for March 2009 @ RM1,250 per metric ton,
and they are not in the palm oil business, they have no
interest in actually receiving or delivering palm oil at
expiration. They are just taking a position on the price of
palm oil in the future.
• Speculators can participate in futures trading because actual
delivery is not required.
61
SPECULATORS - EXAMPLE
• If a speculator thinks that the cash price of
palm oil will go above RM1,250 sometime
between now and June 2009, they take a
LONG POSITION, and buy palm oil futures
contracts. They are speculating that the
P > RM1,250, and will make money if that
happens. They buy @RM1,250 and hope to
sell at P > RM1,250. Speculator is gambling
(betting) that the price of palm oil will be >
RM1,250.
62
SPECULATORS - EXAMPLE
• If the speculator thinks that the cash price of
palm oil will go below RM1,250/metric ton,
he will take a SHORT POSITION, and sell palm
oil futures. He will make money if
P < RM1,250, they are betting that the price
of palm oil will fall.
63
Speculating with Futures Contract
 Speculators deal with price changes that occurred in the
market.
 They are motivated by the strong desire to make profit
on the transaction.
 They will buy the futures at low price and sell at high
price.
 The speculative traders in the futures market help to
fulfil a very important role. They provide the depth and
volume of trading that allow hedgers and others to
enter or exit the market easily.
64
Three types of speculators
–
–
–
The scalpers look out for minimum price fluctuations on
heavy (large) volumes taking small profits at a time. They
aim to make small profits on large volumes of transaction.
The day traders do intraday trading and on small volumes
of trade. The typical day trader would take long or short
positions of a few contracts and would close-out their
positions later in the day when the prices have moved.
The position traders look for long-term price trends and
may hold over weeks, or months before getting out.
65
Using CPO Futures to Speculate
• Outright position speculative strategy
– Takes a view of the change of the futures prices
and speculate on it
– – refer to section 7.5.4.1 page 202
• Spread trading speculative strategy
– Based on expectations of changes in relationship
between several futures contract
– – refer to section 7.5.4.2 page 203
66
EXERCISE:
• A trader takes a view that March FKLI which
are currently trading at 1158.6 are about to
enter a downtrend.
– Should the trader go long or short futures.
– Assuming that the trader maintains his position
until expiry and the cash settlement price is
1125.4, what will be the profit/loss.
• Profit = (1158.6-1125.5) x RM50 = RM1660
67
EXERCISE
• A palm oil producer firmly believes that the
price of crude palm oil is about to enter an
uptrend. It is now October and the trader
buys 6 November CPO futures at RM1,370.
The margin for CPO is RM8,000 per contract.
• Calculate profit and loss on the transaction if
the trader decides to close the contracts on
day 5. The price of FCPO on day 1,2,3,4, and 5
are RM1,235, RM 1,350, RM1,370, RM1,400
and RM 1,398 respectively.
68
EXERCISE
• Suppose in March, the April FCPO contract is trading at
RM1,225 while the May contract is trading at RM1,100.
Assume that between March and April, FCPO fell quite
sharply. The trader anticipates that the spread to be
narrowed.
• Outline the strategy that the trader should take.
• Assume that April FCPO is traded at RM1140 upon
maturity, calculate the profit/loss if the spread between
April FCPO and May FCPO is 70 points.
69
• Spread Narrow
Price
1225
Spread 70 points
1100
Time
• Buy May FCPO and Sell April FCPO
• Profit/Loss = (1210-1100) + (1225-1140)
= 195 X 25
= 4875
70
Arbitraging with Futures Contract
Arbitrage is simultaneous purchase and sale of the same
instrument in different markets to profit from the
temporary price differences or inconsistencies.
How did arbitrage ensure price convergence?
An arbitrage is a trade that involves buying in the
physical market and selling at the futures market at a
higher price.
A trader who initiate the arbitrage if observes the prices
are traded above the ‘fair values’ will act on by selling
the futures where the prices are high and pushes the
price back to the fair value as determined in the physical
market.
Provide liquidity and ensuring the price of cash and
futures converges at the expiry date of the contract.
71
Fair value of futures price using cost
of carry model
F  S (1  r  c  y)
t
where
F
S
r
c
y
t
= futures price for a contract with maturity from
time t to T at maturity
= cash or spot price of the underlying asset
= annualised risk-free interest rate (a proxy for
opportunity cost)
= annualised cost of storage (%) (inclusive of
shipping, handling, shrinkage, spoilage or
damaged, etc)
= convenience yield on the cash commodity
= time to futures expiry expressed on yearly
basis
72
Fair value of futures price using cost
of carry model
•
•
•
•
•
Example:
Spot price = RM1,275
Storage = RM5 per month
Risk-free rate = 4%
1-month Futures contract = RM1000
• Theoretical Fair price:
F = RM1,275 (1 + 0.04 + 5x12/1,275) 30/365
= RM1,283.78
73
• Is it possible to make a gain if the actual
futures price is lower than the fair price? If so,
describe the strategy a trader could use in this
situation.
• If the 1-month FCPO is traded at RM1500.
Calculate the PL if any.
74
Using CPO Futures to Arbitrage
• Find the fair value of the futures price
• If the actual futures price > fair value, overpriced position
– sell futures and buy the spot or physical market
• If the actual futures price < fair value, underpriced
position – buy futures and sell the spot or physical market
• An illustration of how to calculate fair value of the CPO
futures – page 204
• Table 7.7 shows the outcome of arbitraging.
75
Example
• In March, the spot price for CPO is RM975. If
the cost of storage is RM 5 per month and the
risk free rate is 5%, what is the upper limit for
the April futures price assuming the contract
expires in one month?
• FV = 975([1+(0.05 )] + [(5*12/975)])30/365
= 983.51  FV April FCPO
[ April FCPO should trade above this limit]
76
• Assume that April FCPO are currently trading at RM1000
per tonne.
• Arbitrage opportunity exist coz April futures are not
correctly priced, OVERVALUE
• Strategy;
Today;
Sell April FCPO at RM1000/t  coz overvalue
Buy CPO at RM975/t; store at RM5 per month.
Upon maturity, deliver CPO to buyer and receive
RM1000/t.
Profit: 1000 – 975 – 5 = RM20/t
77
EXERCISE
• Today is early October. You believe that
quotations of FKLI are mismatched. Currently
the spot index is quoting at 990 while
November FKLI at 1060. You 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 converged at 1020 in
the last day of November for RM5 million
funds.
78
F  S (1  r  c  y)
t
F = 990 (1+ 6.5% + 0 – 3.5%)61/365
F = 994.90
Overpriced:
Today: Sell 94 Nov FKLI @ 1060
Buy RM5 million shares @ 990. Hold temporarily
Later: Buy 94 Nov FKLI @ 1020
Sell shares that worth
( 5M + ( 1020-990/990)5M= 5151515.152
79
Arbitrage Profit
Description
Profit
Futures Profit
(1060-1020) x 94 x 50
188000
Cash Portfolio
profit
Interest exp
[(1020-990)/990 ] x 5M
151515
6.5% x 5 M x 61/365
(54315)
Div yield
3.5% x 5M x 61/365
29247
TOTAL
314447
80
EXERCISE
• Your bank is willing to finance the purchase of
physical shares for 3M through arbitrage
activity. You observe that the spot index is
currently trading at 965 while July FKLI at
1088. Assuming your cost of funds is 7.5% per
annum and dividend yield of 4.5% for 90 day’s
holding. Show your arbitrage profit (if any) if
July FKLI converge with KLCI at 1050 upon
maturity.
81
• F = 972.05
• No of Contract = 3M /(1088 x 50) = 55 contracts
• Today
– Sell 55 July @ 1088
– Buy RM 3M shares on a borrowed funds  CI 965
• Later
–
–
–
–
Buy 55 July @ 1050
Sell Shares @ [3M+(1050-965/965)x3M]= 3,264,248.70
Receive dividend for 90 days
Pay interest for 90 days
• Profit
– (3,264,248.70 -3M) + (4.5% x 3M)90/365 –
(7.5%x3M)90/365 + (1088 – 1050)55 x 50
–=
82
Example;
•
•
•
•
•
•
Suppose you observe the following quotations today.
3-month FKLI price
=
1,210
Index value
=
1,200 pts
rf rate
=
4%
Dividend Yield
=
2%
Time to maturity of SIF
=
90 days
• To see if arbitrage is possible we first check for mispricing. The
correct value of the 3-month FKLI should be;
• Ft
=
=
=
1,200 (1+.04-.02)0.25
1,200 (1.02)0.25
1,205.96 points
Given the above information, the futures is clearly overpriced relative to spot.
The futures price should be 1,205.96 points, yet it is quoted at 1,210 points.
Overpriced by approximately 4 points.
Since there is mispricing, arbitrage is possible. By using the following arbitrage
strategy a riskless profit can be made. (Note that no cash outlay is needed
today
we will look at 2 market scenarios. (Note: current stock index value is 1,200 pts)
•Index Rises to 1225 at maturity
•Index Falls to 1175 at maturity
Scenario 1: Index Rises to 1225
Cash & Carry Arbitrage
Action
FKLI
Position
Today
Position At
Maturity
Profit/Loss
60,500
(1210 x 50)
(61,250)
(750)
(60,000)
61,250
1,250
(I)
Short
1
Contract
(I)
Long Spot
(I)
Borrow RM60,000
@ 4% for 90 days.
60,000
(60,591.20)
(591.20)
(I)
Receive divs. and
invest it @ 4% for 90
days.
0
303
303
Net =
211.80
Scenario 2: Index Falls to 1175
Cash & Carry Arbitrage
Action
FKLI
Position
Today
Position At
Maturity
Profit/Loss
60,500
(58,750)
1,750
(60,000)
58,750
(1,250)
(I)
Short
1
Contract
(I)
Long Spot
(I)
Borrow RM60,000
@ 4% for 90 days.
60,000
(60,591.20)
(591.20)
(I)
Receive divs. and
invest it @ 4% for
90 days.
0
303
303
Net =
211.80
Reverse Cash and Carry Arbitrage
Suppose in the above example, the Futures price today is quoted as;
3-month SIF price = 1201
Now, the SIF is underpriced relative to spot. In order to arbitrage we need to do
the reverse of the earlier strategy
The following reverse Cash and Carry arbitrage would be appropriate here
Index Rises to 1225
Action
Position
Today
Position At
Maturity
Profit/Loss
(I)
Long 1 SIF Contract
60,050
61,250
1,200
(I)
Short Spot
60,000
(61,250)
(1,250)
(I)
Lend RM60,000 @
4% for 90 days.
(60,000)
60,591.20
591.20
(I)
Borrow RM300 @
4% to replace divs.
on borrowed shares
(shorted).
0
(303)
(303)
Net =
238.20
Index Falls to 1175
Action
Position
Today
Position At
Maturity
Profit/Loss
(I)
Long 1 SIF Contract
60,050
58,750
(1,300)
(I)
Short Spot
60,000
(58,750)
1,250
(I)
Lend RM60,000 @
4% for 90 days.
(60,000)
60,591.20
591.20
(I)
Borrow RM300 @
4% to replace divs.
on borrowed shares
(shorted).
0
(303)
(303)
Net =
238.20
Single Stock Futures (SSFs)
• SSFs are based on individual stocks listed in
Bursa Malaysia and therefore, it tracks the
movement of the individual underlying stock.
• As of now, there are 9 SSF contracts.
• The contract specification – refer to Table
7.10 page 213.
90