DERIVATIVES MARKET

FIN 250
Learning outcomes:

Define derivatives

Categorised two types of derivatives

Explain the uses of future instruments by institutional participants

Differentiate between futures and option

Describe basic illustration of futures and options trading

 INTRODUCTION

◦ WHAT IS DERIVATIVES?
Financial instruments used to manage exposure to risk ie: market volatilities
Provides an avenue where domestic an d international market participants can
manage their risk exposure in an efficient and cost-effective manner.

Use derivatives
Volatile Company products
RISK objective is to
market manage risk
Eg: Future and
option
◦ 2 TYPES OF DERIVATIVES
Exchange-traded (ETD)
Contracts that are traded on derivatives exchange which are standardised as
f=defined by the exchange. The counter-party to all contracts is the derivatives
Exchange itself

Over-the-counter (OTC)
Contracts that are privately negotiated and traded directly between two
parties. The contract are tailored to investors’ requirements and OTC is the
largest market for derivatives
 DERIVATIVES MARKET IN MALAYSIA
◦ HISTORICALLY DEVELOPMENT
July 1980 - Kuala Lumpur Commodity Exchange (KLCE), the first future exchange in South East Asia was
established to offer palm oil futures contract .
Dec 1995 – formation of Kuala Lumpur Options and Financial Futures Exchange (KLOFFE) commenced its
operations by launching a stock index futures contract called KLSE Index futures. It is considered as one of he
milestones in the development of Malaysian capital market.
May 1996 – the Malaysian Monetary Exchange (MME) was set up to facilitate the trading of three-month
KLIBOR Future contract and Crude Palm oil (CPO) Futures.
Dec 1998 – KLCE merged with MME and change name to Commodity and Monetary Exchange of Malaysia
(COMMEX) to become Malaysian Derivatives Exchange of Malaysia (COMMEX) to reflex the diversity of the
products.
Jan 1999 – KLOFFE became a subsidiary of the KLSE Group of Companies.
June 2001 – Reorganization of exchanges by merging the two exchanges (KLOFFE and COMMEX) to become
the Malaysia Derivative Exchange (MDEX) by trading 4 derivatives during that time namely KLSE Composite
Index Futures Contract, the KLIBOR Future Contract and the KLSE Composite Options contract.
2004 – MDEX is now know as the Bursa Malaysia Derivatives Berhad until now.
◦ REGULATORY AND LEGAL FRAMEWORK
Ø Governed by the Futures Industry Act 1993, later amended in 1995 and 1998
Ø The act give power to the Ministry of Finance which in turn empowered the Securities Commission
Malaysia (SC) to regulate the industry to ensure market integrity and protecting the investors

Ø SC – Responsible to give license to Future brokers, trading advisers, fund managers and representative.
- Supervise KLOFFE and MME

◦ DERIVATIVES CLEARING HOUSE

Ø Malaysian Derivatives Clearing House Berhad (MDCH) established in 1995
Ø Later change to Bursa Malaysia Derivatives Clearing House
Ø Provides financial stability by guaranteeing the performance of all contracts as it acts as the
counterparty to all contract traded. It assumes the role of ‘buyer’ to the seller and ‘seller’ to a buyer,
thus, the actual buyer and seller does not exist.
ØThe guarantee is supported by the collection of margin payment from the buyer and seller.
MARKET PARTICIPANTS AND ITS USES
◦ Participants in the derivative market comprised of those who are concerned
with the movement of interest rates, commodity prices, share prices and
exchange rates. The movement can be very volatile which cause losses on the
part of the participants.
◦ Participants can be either a hedger or a speculators, which include investment
banker, fund manager, multinational corporations, financial institutions,
commodity producers and other participants such as general businesses.
◦ USES OF DERIVATIVES
Ø Future and Options are often use as risk
management tool to safeguard investment for the
uncertainty of future market directions.

Ø SPECULATORS - Can become a market for

speculative purpose to make profits by capitalising the
differences in the futures prices.

◦ HEDGING - Participants use derivatives product

such as futures to protect themselves from price
uncertainty. In the case of futures trading for the
purpose of hedging, normally a hedger will perform
two counter-balancing transactions, (i) buying or
selling the financial instrument or the commodity
itself, and (il) buying and selling the futures contract.
◦ If a commodity price is expected to decrease in the
future, resulting in losses if you need to sell it at that
future date, the losses can be offset by selling the
futures now (short trade) and later buy back the
futures during the time when you sell the commodity.
So the losses in the commodity transaction are
reduced by the profits in the futures contract.
 DERIVATIVES PRODUCTS
◦ The following products are currently traded on the Bursa Malaysia Derivatives Berhad:
ØKLCI (FKLI) Futures
ØKLCI (OKLI) Options
Ø3-Month Kuala Lumpur Interbank Offered Rate interest rate (FKB3) Futures
ØCrude Palm Oil (FCPO) Futures
Ø3-Year Malaysian Government Securities (FMG3) Futures
Ø5-Year Malavsian Government Securities (FMG5) Futures
Ø10-Year Malaysian Government Securities (FMGA) Futures
ØCrude Palm Kernel Oil (FPKO) Futures
ØSingle Stock Futures (SSFs)
ØEthvlene OTC Futures Contract
 FUTURES & OPTIONS
◦ Futures and options are basic derivative instruments whose values
are dependent on the value of an underlying asset such as stocks,
bonds, indices, currencies or commodities.
◦ It is high-risk type of instrument and it is important to fully
understand the risks and financial liabilities involved in the trading of
futures and options.

FUTURES CONTRACT
◦ Represent an agreement between a buyer and a seller to exchange
a specified amount of cash for a specific asset at a future date.
◦ Futures contract is traded on an exchange with a standardised
agreement at which there are specifications on the exact amount
and quality of goods to be bought or sold at a fixed price at a fixed
future date.
◦ The contracts are also known to all other interested participants not
exclusively arranged between the two parties only.
'OPEN POSITION' AND 'CLOSE OUT'
◦ A futures contract has an expiry date, which is the last day of trading in the particular contract month.
◦ If the futures is still 'opened' on the expiry date, then the parties must make the delivery of the asset or
cash settlement. In other words when you buy a futures contract, it requires you to take delivery of the
goods, or to make delivery if you sell the contract, unless your position is 'closed’.
◦ However in most cases, delivery exchange does not take place and positions are closed out or resold
before the expiry date.
◦ This is because the main purpose of futures trading is not to buy or sell the commodities, physical goods or
financial instruments but to manage the risk of price volatilities or for the speculators to make profit.
◦ As the market price of the futures goods fluctuates during the contract period, there will be a difference
between the contract price and the market price showing a gain or loss in the futures contract value.
◦ Most traders will close out their contracts (taking an opposite position), when they feel the contract value
has risen or fallen in their favour. For example, if a trader has bought a futures contract, he will sell it to
close out when the price has gone up. On the other hand, if a trader has sold a futures contract, he will buy
it back to close out when prices drops.
MARGIN REQUIREMENT
o All futures market participants must deposit an initial sum of money or
other acceptable collateral with their futures brokers in futures margin
accounts to guarantee contract obligations, before they can start
trading.

o This is known as the initial margin which is set by the Malaysian

Derivatives Clearing House. Margin requirements can vary depending
on market volatility and other factors at the prerogative of the clearing
house. Even though the clearing house sets a minimum margin level,
futures broker normally prefers a higher margin to further protect the
risk which is known as the variation margin.

oAny gains or losses are added or subtracted daily from the clients
margin account based on the close of that day's trading session using a
mark to market system.
 Summary
Definition Contracts made between two parties to buy and sell a standard quantity of financial
instruments for settlement at a specified future date

Financial Interest rates, currencies, stock prices, commodities

instruments

Obligation: Both parties (buyer and seller) agree on a price now for a product to be delivered in future

Contract • Size (Principal value) RM

Specificatio • Delivery date
ns: • Price quotation
 OPTIONS
OPTIONS
◦ Options give the buyer/holder of the option the right, but not the obligation, to buy or sell a specified asset at
a specified price (strike price), at or before a specified date from the seller.
◦ Two main differences between options and futures are:
Ø Buyer of options has to pay a premium in addition to the price of the financial instrument
Ø Options holder can let the options expire on the expiration date without exercising it. The premium limits
the buyer's potential loss in the options market to the amount of the premium paid.

◦ CALLS AND PUTS

Ø A call option gives the buyer (holder) the right to buy (not obligation) an underlying asset. So buyer of call
option can choose whether or not it would be profitable to buy the asset. If option price is higher than
market price of asset then holder of option can let the option to expire.
Ø Options that give the buyer the right to sell an asset are known as put option. Buyer of put option can
decide whether it is profitable to sell the underlying asset and act accordingly.
Ø The seller of the option (option writer) has an obligation to deliver the specified instrument at the specified
price if option owner exercise the options. The seller receive compensation in the form of the premium paid
by the option buyer (up-front fee)
TYPES OF OPTIONS STYLES
◦ There are two option styles - (i) American option and (i) European option
Ø American style options can be exercised by the buyer at any time from the date of purchase up until (and
including) the expiry date.
Ø European style options can be exercised by the buyer only on the specified expiry date.
Eg: country's first options, the stock index options on the KLSE Composite

STRIKE PRICE AND OPTION STATUS

Ø The strike price or exercise price is the price at which the underlying asset will be bought or sold if the
holder of option wants to exercise the option.
Ø This strike price is normally set in the form of a range both below and above the current market price of an
asset.
Ø If the market price of the asset exceeds the strike price then the option is said to be ‘in the money’ - a
favourable status to the option buyer.
Ø If market price is less than the strike price the option is option is considered as not favourable or known
as ‘out of the money’.
Ø If market price is equal to the strike price, the option is at the money.
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