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The Agricultural Commodity

D i ti
Derivatives
Markets
M k t

Agenda
1 How the Futures Market Works.
1.How
Works
The History of the Futures Market, Modern Futures
Trading, Contracts Specifications, Trading Practicalities.

2.Using Futures to Hedge.


Definition, Why Hedge, (Dis)Advantages of Hedging,
Implementing a Hedge, Imperfections.

3.Speculating with Futures.


Role of Speculators,
Speculators Outright Positions,
Positions Spread Trading.
Trading

4.Arbitraging with Futures.


Role of Arbitrageurs, Futures Fair Value, Arbitrage Trades.
2

Futures - The Definition


Futures contracts are standardized legal
agreements to buy/sell a commodity or
financial instrument to be delivered at
some time in the future. The quantity,
quality, price and delivery period will
be specified in the contract.
contract
3

F
Futures
- Example.
E
l

ABC buys 10 lots of May 03 crude palm


oil
il futures
f t
contract
t t att 1630.
1630
It is therefore an agreement to buy 250
tons of crude palm oil to be delivered in
M at the
May
h price
i off RM1
RM1,630
630 per ton.
4

Futures - The History.


No proper regulated Exchange.
Earliest known futures contract can be traced back
to the 12th century
y in Europe.
p
Merchants sold forward their goods well before they
arrived at the ports. The price of the goods were
settled at the time the agreement was reached.
Seller is,
is therefore,
therefore protected against any fall in
prices and buyers, on the other hand, against any
increase in price.
price
5

F
Futures
- The
Th Hi
History.
The same mechanism was created in the US
in the 19th century.
y Tradingg was for
commodities like cotton and grains.
Merchants came from as far as across the
Atlantic Ocean.
Brokers came into existence. Traded on
behalf of buyers
y and clients. Gathered in one
place, which is now known as the futures
exchange.
6

Futures - Modern Trading


Trading.

Commodity
C
dit exchanges
h
were established
t bli h d in
i
Chicago, London & other parts in Europe.
Clearing houses were also established to clear
and guarantee agreements.
agreements
Not only to buy/sell commodities, but may be
usedd to manage risks
ik
7

Futures- Examples of Futures


Contracts.
Stock Index Futures, Stock Futures,
Crude Palm Oil Futures, Crude Oil,
Soyoil Futures
Futures, Soybean
Futures,Heating Gas Futures, Cattle
Futures, Gold Futures, Silver Futures,
Currency Futures,
Futures Interest Rates
Futures, Bond Futures.
8

Futures - What Do We Need?


1. Liquidity - large
amounts off bbuyers andd
sellers.
2. Commodity/Product
must be easily graded.
3. Prompt performance
of contracts.

4. Efficient Clearing
H
House.
5. Transparency.
6. Stringent regulation of
Exchanges.
g
7. Accessible to public.

Crude Palm Oil Futures


Contract Specifications.
ifi i
Underlying
Instrument

Commodity Instrument which


form the Crude Palm Oil
F t res in
Futures
i Bursa
B
Malaysia
M l i
Derivatives

Contract
C
Months

Spot month,
month the ne
nextt 5
succeeding months, and
thereafter, alternate months up to
24 months
th forward
f
d
Ringgit Malaysia

Price Quotations

10

Crude Palm Oil Futures


C
Contract
Specifications.
S ifi i
Contract Size

The size of the underlying


instrument. E.g. 1 lot of CPO
futures = 25 metric tons.

Mode of Delivery
y

Cash settlement or physical


d li
delivery.
(Only
(O l takes
t k place
l
if
contract is held up to expiry).

Grade

The quality of the underlying. E.g.


CPO, Free of fatty acids of palm oil
delivered into Port tank Installations
shall not exceed 4% and from Port
Tank Installations shall not exceed
5%. Moisture and impurities shall
not exceed 0.25%.
11

Ribbed Smoke Sheet No. 3 Futures


Contract Specifications.
ifi i
Underlying
Instrument

Commodity Instrument which


form the Ribbed Smoke Sheet
No 3 in Tokyo Commodity
No.
Exchange

Contract
C
t t
Months

Six consecutive months

Price Quotations

Japanese Yen

12

Ribbed Smoke Sheet No. 3 Futures


Contract Specifications.
ifi i
Contract Size

The size of the underlying


instrument. E.g.
g 1 lot of
RSS3 futures = 5,000 kg (5
tonnes) / contract

Mode of Delivery

.
Cash settlement or physical
delivery. (Only takes place if
contract
t t is
i held
h ld up to
t expiry).
i )

Grade

Ribbed Smoke Sheet No. 3

13

Cocoa Futures
Contract Specifications.
ifi i
Underlying
Instrument

Commodity Instrument which


form the Cocoa in
Intercontinental Exchange US
(ICE US)

Contract
Months

March, May
March
May, July,
July September,
September
December

Price Quotations

US Dollar

14

Cocoa Futures
Contract Specifications.
ifi i
Contract Size

Mode of Delivery

The size of the underlying


g 1 lot of RSS3
instrument. E.g.
futures = 10 metric tons /
contract
.
Physical delivery. (Only takes
place if contract is held up to
expiry).
expiry)
Cocoa

Grade

15

Coffee Futures
Contract Specifications.
ifi i
Underlying
Instrument

Commodity Instrument which


form the Coffee C in
Intercontinental Exchange US
(ICE US)

Contract
Months

March, May,
March
May July,
July September,
September
December

Price Quotations

US Dollar

16

Coffee Futures
Contract Specifications.
ifi i
Contract Size

Mode of Delivery
Grade

The size of the underlying


instrument. E.g. 1 lot of RSS3
futures = 37,500 Pounds /
contract
.
Physical delivery. (Only takes
place if contract is held up to
expiry).
Coffee Grade

17

Futures
Trading
di Practicalities.
i li i
1. Long vs. Short Futures.
2 Basis - The spread
2.
spread
between the futures price
and the cash price. E.g.
March futures is trading at
1980, physical market at
1950 The
1950.
Th basis
b i will
ill be
b 30
points.
3 Position Limits - Most
3.
Exchanges may impose
pposition limits on a single
g
account.

4. Price Limits - Most


Exchanges will set daily
price limits.
--> Both Position limits and
Price limits are to avoid
the ppossibilityy of
disruption to the market
and the opportunity to a
th financial
fi
i l impact
i
t
assess the
of changing
circumstances
circumstances.
18

Futures
Trading
di Practicalities.
i li i
5. Leverage
Simply put,
put for a small
amount of margin, you
will get to trade a
contract which is
greater in value.
value E.g.
Eg
For RM2500, 1 lot of
FCPO futures =
49,750 (1990 x 25)

Assume CPO moves by


5% Th
5%.
Therefore
f
new
CPO level is at 2090.
I terms off RM
In
RM, you
would have made 100
points
i x 25.
25 Thus,
Th
Return on Investment
= 100% bbase on the
h
margin of RM2,500
19

Futures
Trading
di Practicalities.
i li i
6. Volume.
-- The total amount of
buy or sell in a
particular trading
session or trading day.
Do not confuse with
total buy AND sell
combined.

7. Open Interest.
Total amount of futures
contract which remains
open at the end of the
trading day.

20

Futures
Trading
di Practicalities.
i li i
8. Backwardation.
Thi scenario
This
i happens
h
when
h
the spot month futures
contract is trading below
the underlying market
price. All other contract
p
months are also below the
spot month.
Also referred to as a discount
market.

9. Contango
Thi scenario
This
i is
i the
h opposite
i
of Backwardation. Futures
price is trading above the
underlying market price.
Far month contracts are
trading higher than the
spot month contract.
Also known as a premium
market.
21

FUTURES

HEDGING
22

Ui F
Using
Futures to H
Hedge.
d
Normally, in a typical market, there is bound
to be volatility in the market. Sometimes,
g and create risks to
the volatilityy can be huge
players in the underlying market. Therefore,
to limit
limit these risks,
risks players can use the
futures market as a form of insurance

23

H d i - Volatility
Hedging
V l ili Example.
E
l
.KLSE, Close(Last Trade) [Line] Daily
08Oct97 - 08Mar03
Pr
MYR
800
600
.KLSE
KLSE , Close(Last Trade)
30Jan03 664.99
98

99

00

01

02

400
03
24

F
Futures
- What
Wh is
i Hedging?
H d i ?
It is the taking of a futures position (buy
or sell) in anticipation of a later
transaction in the underlying market
OR taking a futures position which is
directly opposite to the existing
position held in the underlying market.
market
25

F
Futures
- Why
Wh Hedge?
H d ?
The profitability of most companies is
dependant very much on the volatility of
various commodities and financial
instrument.
E g Airlines companies dependence on oil
E.g.
prices. Construction projects (borrowers)
dependence on interest rates.
26

F
Futures
- Why
Wh Hedge?
H d ?
Similarly, financial institutions, who are lenders, are
subjected
bj
d to fluctuations
fl
i
in
i interest
i
rates.
Therefore, to protect against any adverse movement
which could affect the profitability of the
company, hedging on the futures market could
provide the means to offset these risks.
g g is about pprotecting
g and ppreserving
g the
Hedging
profitability and wealth of the company/individual.
27

H d i - Advantages.
Hedging
Ad
1. Provide options during extreme market
volatility.
2 Positions may be closed out as volatility
2.
subsides.
3. Cost off entry / exit
i is
i cheaper.
h
4. Provide time to analyze situation.
5. Achieve P/L objections
28

H d i - Advantages.
Hedging
Ad
3. Leveraging.
Despite the huge amount of portfolio on the
cash market, hedging on the futures market
d
does
not involve
i
l the
h same amount off money
due to the leveraging concept.
4. Convergence of Underlying and Futures
Market This is for Cash Settlement
Market.
contracts.
29

H d i - Disadvantages.
Hedging
Di d
1. Standardized Contracts.
Futures contracts are all standardized. Cannot be altered.
May be difficult to obtain a perfect hedge. E.g. A refiner
with 85 tons of palm oil will find it difficult to hedge his
positions.
ii
He
H would
ld have
h
to sell
ll either
i h 3 lots
l off CPO
futures (in this case, he is under hedged) or sell 4 lots (in
this case,
case over hedged).
hedged)
2. Initial and Variation of Margins. (Undeveloped Exchange)
Hedgers will have to come up with initial margin to open up
a hedge position and provide variation margins for
unfavorable movements on the sell ppositions.
30

H d i - Disadvantages.
Hedging
Di d
3. Forego Benefits of Favorable Movements.
Despite its benefits, a hedge would result in the
hedger
g having
g to forgo
g favorable pprice movements.
E.g. If Shell Refinery sells crude oil futures in
anticipation of a decline in world crude oil prices,
any upward movement in prices at a later date
would result in it realizing smaller
smaller profits despite
the favorable movement in prices.
31

H d i - How
Hedging
H T
To Hedge.
H d
To hedge a particular underlying exposure,
there are a few considerations which have to
be made before the hedge
g can be
implemented. Failure to establish this would
result in the hedge not working in favor of
the strategy.

32

H d i -How
Hedging
H to H
Hedge?
d ?
1. How much?
It is important to
identify the amount of
portfolio to be hedged.
Normally, a hedger
does not hedge 100%
of its portfolio for
obvious reasons.

2. Delivery Month?
Also must establish how
Also,
long the hedge position is
to be held. If this is
established, then can go on
to decide which contract
month to use.
use Ideally,
Ideally it
should be the same month
as when the transaction on
th underlying
the
d l i market
k t is
i to
t
take place.
33

H d i -How
Hedging
H to H
Hedge?
d ?
Anticipatory or Hedging a Current Market Position?
T hedge
To
h d a current market
k position,
i i it
i is
i always
l
done
d
by
b
taking a directly opposite position to the underlying market.
If long on stocks,
stocks then to hedge,
hedge a hedger would be selling
futures.
On the other hand, in an anticipatory hedging scenario,
establish first what would be done in the underlying
market. If selling commodity at a later date, then sell
futures first. Similarly, the opposite applies.

34

Anticipatory Hedging - Example.


Example
Assume XYZ Airline expects crude oil prices to rise in
coming months due to certain geopolitical factors.
factors As they
would need crude oil prices at current levels to protect its
p
profits,
p
, XYZ Airline would be buying
y g crude oil
operational
futures contracts.
Assume, NYMEX crude oil futures is trading at
Assume
US$33.00/barrel. If XYZ Airlines buy crude oil futures at
this price and later the NYMEX crude oil futures rises to
US$36.00/barrel, XYZ Airline would have avoided having
to buy crude oil at higher prices.
35

H d IImperfections.
Hedge
f i
There would be occasions where the hedge
strategy is deemed to be imperfect. Due to
the standardized nature of futures contracts,,
a hedge imperfection is bound to happen.
Therefore it is prudent to consider some of
Therefore,
the risks involved in implementing a hedge
strategy.
t t
36

H d IImperfections
Hedge
f i
- Risks.
Ri k
1. Basis Risk.
Risk where the correlation between the underlying
instrument to be hedged and the futures contract is not
entirely perfect.
E.g The FCPO futures contract represents 25 metric tons of
Crude Palm Oil. However, an investor may be trading in
Palm Olein instead. Correlation may diverge.
Also, there may be times where the futures price and the
underlying instrument price lacks the convergence at
expiration. Illiquid and non-transparent market in a physical
delivery contract. Locals non-existence.
37

Hedge Imperfection
Basis
i Risks
ik
Delivery Basis

Grade Basis

Location Basis

Relates to cost of delivery for


deliverable futures contracts, e.g. CPO
futures. Cost of delivery includes cost
of funding, storage costs, and insuring
the commodity until delivery
delivery.
The grade of the underlying instrument
may not be the same as the required
grade
d ffor the
h futures
f
contract. E.g.
E
CPO futures.
Prices mayy be different depending
p
g on
its location. E.g. CPO prices in East
and West Malaysia differs.
38

FUTURES
SPECULATING
WITH FUTURES
39

Th Need
The
N d ffor S
Speculators.
l
Speculators and individuals and institutions who
f
form
a trading
di view
i off the
h direction
di i off the
h futures
f
market. They participate in the futures market with
the
h objective
bj i to achieve
hi
profits
fi by
b taking
ki this
hi
trading view.
In pursuing this objective, they will be assuming the
price risk that hedgers seek to avoid.
Speculators provide liquidity to the market to enable
hedging
g g and arbitraging
g g to take place.
p
40

Why Speculators Are Attracted


to the
h Market.
k
1. High Leverage.
-- Huge profit potential
2. Low transaction costs.
-- Cheap and negotiable.
3 Transparent market.
3.
market
-- All have equal access
to the
h market.
k

4. For institutional
li
minimal
i i l
clients,
operational
requirements.
i
5. Two way market
-- Capture both uptrend
and downtrend.

41

O i h Trading.
Outright
T di
Speculators normally form a view that the
market would either rise or decline.
Depending on the current sentiment,
sentiment
speculators will buy or sell futures contracts
with the hope of making money from this
view.
Trading plan is either buy or sell only.
42

O i h Trading
Outright
T di - Example.
E
l
X believes that the FCPO would be rising in the next
f sessions
few
i
based
b d on the
h technical
h i l analysis.
l i There
Th
are buy signals for the market. Hopes to capture
this
hi uptrend.
d
Buy FCPO March 04 futures at 1990 on 1st March
2004.
y 3rd March 2004,, futures rises to 2058.
By
X sell March 04 futures contract at 2058.
43

O i h Trading
Outright
T di - Example.
E
l
2080
2060
2040
2020
2000
1980
1960
1940

02/

2
01/ 003
03/
2
02/ 003
03/
2
03/ 003
03/
200
3

Mar Futures

28/

Profit made from transaction :


Long 1 lot @ 1990.
Sell 1 lot @ 2058.
Profit : = 68 points
= RM1,700
RM1 700

44

O i h Trading
Outright
T di - Example.
E
l
Assume now that the market is bearish. Due to
geopolitical factors, the market may be
headingg downwards.
Y will sell 1 lot of March 04 futures contract
at 1685 on 26th March 2004.
2004 March 04
expires at 1650 on 28th March.

45

O i h Trading
Outright
T di -Example.
E
l
690

Profits :
680
Sell 1 lot @ 1685
670
Expired @ 1650
660
Profit : 1685 - 1650
= 35 points x RM25 650
640
= RM875.
RM875

Mar Fu

630
26/03

27/03

28/03
46

Speculators
Types off Speculative
l i Traders
d
1. Scalpers
-- Trades on minimum price fluctuations
-- Heavy trading volume
positions
-- Rarely hold overnight positions.
2. Day Traders
-- Trade on an intra-day basis
basis.
-- Trading volume may be smaller compared to scalpers.
3 Position Traders.
3.
Traders
-- Trades on long term price trends.
47

S
Spread
dT
Trading.
di
1. Speculative trading.
2. Involves the simultaneous buying in one
contract month and sell in another contract
month.
3. Lower risk.
ik
4. Profit from a change in the difference of the
two futures prices.
48

Spread Trading
T
Terminology
i l
Intracommodity Spread.
A trade of two different
contract months but
same commodity.
g Buyy April
p CPO
E.g.
futures, sell May CPO
futures.
Also known as
calendar/time spread.
spread

Intercommodity Spread
A trade in one contract
and a trade in another
but economically
related contract.
E.g. Buy April CPO
futures,, a sell on soyoil
y
futures.
49

0 4 /2 8 /0 3

0 4 /2 1 /0 3

0 4 /1 4 /0 3

1700
1650
1600
1550
1500

0 4 /0 7 /0 3

I
Intracommodity
di Spread
S
d

Apr CPO

Apr CPO
May CPO

50

I
Intercommodity/Market
di /M k Spread
S
d

1200

STI Futures
KLCI Futures
600

STI Futures

March Mayy

51

I
Intercommodity
di Spread
S
d
Assume SGD$1.00 =
RM1 00
RM1.00
Assume 1 point on STI
Futures = SGD$100
Sell 1 lot STI Futures @
1,300.
Settle @ 1,245
Profit : 1,300
1 300-11,245
245
= 55 points
SGD$5,500/RM5,500
500/RM5 500
=SGD$5

On the KLCI futures, buy 1


lot @ 680.00
680 00
Market down to 670.00
Lost : 680.00
680 00 - 670.00
670 00
= 10 points
= RM1,000
RM1 000
Profit : RM5,500 - RM1,000
= RM4,500.
RM4 500

52

I
Intracommodity
di Spread
S
d
Buy Apr. 03 CPO @
1680
Market declines to 1550.
Lost : 1680 - 1550
= 130 points
= 130 x RM25
= RM3,250
RM3 250

Sell May 03 CPO @


1710
Market declines to 1520.
Gains : 1710 - 1520
= 190 points
= 190 x RM25
= RM4,750
RM4 750
Net Effect : Gain
RM1,500
53

FUTURES
ARBITRAGING

54

R l off Arbitrageurs.
Role
A bi
Arbitrage : Definition
-- The simultaneous purchase and sale of the
same instrument in different markets.
E.g. Buy Kuala Lumpur Composite Index stocks,
sell KLCI Futures.
Purpose : To profit from price discrepancies.
Provide liquidity to the market and ensure
convergence of both markets at expiration.
D t
Determine
i fair
f i value.
l
55

0 3 /2 4 /0 3

0 3 /1 7 /0 3

0 3 /1 0 /0 3

705
690
675
660
645
630

0 3 /0 3 /0 3

A bi
Arbitrage
- Example.
E
l

KLCI

KLCI
KLCI Futures

56

F
Futures
- Fair
F i V
Value
l
Definition : Price at which the futures contract should
theoretically
h
i ll be
b trading.
di
Futures = Current price of Underlying Instrument
(consideration given to price of underlying during
arbitrage tenure) + Cost of Carry.
Cost of Carry = Current Interest Rates+ Return on the
underlying
y g commodity+
y Storage
g cost+Actual Time
to Expiration + Transportation Cost.
57

F
Futures
- Fair
F i V
Value.
l
F = S(1+r+c-y)
F = Futures Price
S = Cash Price
r = Risk Free Interest Rate
c = Cost of Storage (%)
y = Yield on the cash commodity (dividend)
t = Time to Expiration.
g cost
B = brokerage
58

A bi
Arbitrage
- Example
E
l
Assume KLCI @ 680.00
Ri k Free
Risk
F Interest
I
Rate
R = 3.50%
3 50%
Cost of Storage = 0.00%
Yield
i ld on Cashh Commodity
di = 2.00%
Days to Expiration = 3 months
F = 680[(1+0.035+0.00-0.02)
Futures Fair Value = 682.54
* These figures are simplified detail considerations are
important and could be a significant sum
59

A bi
Arbitrage

60

A bi
Arbitrage

61

Thank You.
You

Presented by Don Schellenberg


CEO Smart Money Traders
62