Week 5

Question 1

(1) You are a palm oil trader. You have a commitment to buy 1,000 tons of crude palm
oil (CPO) from a miller, and another commitment to sell 1,000 tons of CPO to a refiner.
The transaction will take place in one-month time. Assume it is now 13th June 2019 and
the spot price is RM2,260 per ton, while futures quotes are as follows:

Contract Month June July August September

Price (RM per ton) 2,268 2,277 2,275 2,272

Suppose you have already committed to a price for purchasing the CPO from the
miller at RM2,265/t. The refiner, however, has decided to wait before setting the
price.

i) What direction of CPO price movement would be harmful to your position?

ii) How are you going to hedge your exposure? Is this an anticipatory hedging or a
current market position hedging? Which contract month are you going to trade, and at
what price? How many CPO futures contracts are you going to take out?

iii) How much profit have you locked in part (i)?

(2) Based on the news below, answer the following questions.

The CPO October futures, the most active contract month yesterday, breached the
RM1,600 per tonne level. They closed RM46 higher at RM1,620 with 13,923 contracts
traded…………….CPO dealers, meanwhile, attributed the high CPO prices and volume
traded to the current biodiesel theme, as well as anticipation of strong demand from
traditional buyers like China and India.
A dealer said: “The uptrend in the price of CPO will be more intense owing to a
structural rise in demand for CPO.”
He said the current CPO discount of about 47% to rapeseed and 25% to soyabean
would further narrow as CPO became a source for non-edible purposes, such as biodiesel
and feedstock, for power plants.

i) If you are a speculator, what would be your outlook on the CPO market and what
would be your strategy in the futures market if you were to go for an outright
speculation?
ii) If you plan to buy CPO from a miller in October, with current market sentiments
above, what would be your hedging strategy? Explain your rationale of taking on such
strategy.
(3) A palm oil producer expects to have 85 tons of crude palm oil (CPO) ready for sale on
20th September 2019. He wants to use the CPO futures contracts that are traded on Bursa
Malaysia Derivatives Bhd. to hedge against any adverse movement of the price of CPO.
Today, on 7th of June 2019, the following contracts are available and are trading at the
prices shown in the table:

Contract Price (RM/ton)

June 2019 2,993
July 2019 2,982
August 2019 2,957
September 2019 2,929
October 2019 2,897
November 2019 2,870
January 2020 2,844
March 2020 2,839
May 2020 2,839

To hedge his exposure in the crude palm oil price risk, what will be his strategy? In your
answer, state the position (long or short), the number of contracts to be traded and which
contract should be chosen at what price. In this hedging exercise, what type(s) of
mismatch is(are) present?

(4) Find the fair value of a July CPO futures contract (assume it will mature exactly 3
months from today) given the spot price of CPO is RM2,000/ton, the risk-free rate is 4%
p.a. and the storage cost is 4% p.a. If the July CPO futures contract is now trading at
RM2,200, is there any arbitrage opportunity? If there is, what will be your arbitrage
strategy now?

Guideline answer
Tutorial CPO futures
Question 1
i) The decline in the price of CPO will be adverse to me. This is because I had
already locked-in my purchase price from the miller at RM2,265 but had not
locked-in my selling price. If the price of CPO goes down, my profit margin will
shrink.

ii) The strategy is to sell the CPO futures now in order to lock-in my selling price / to
hedge against a drop in the price of CPO.
This is an anticipatory hedge – no position in the spot market now, but intend to
take position in the spot market in the future.
 I will trade the July CPO futures contract since the delivery of CPO will take
place in September. The price of the July CPO futures contract is RM2,277/t

The number of contracts = Amount to be hedged / Contract Size

= 1000 tons / 25 tons
= 40 contracts

iii) By selling 40 contracts of July CPO futures at RM2,277/t, I manage to lock-in my

profit at RM2,277/t – RM2,265/t = RM12/t. Or RM12/t x 1,000 tons = RM12,000

QUESTION 2

(a) Bullish- long futures

(b) Long futures to lock in the price today.

QUESTION 3

This is an anticipatory hedging where the palm oil producer does not have the physical
CPO yet but he intends to sell the 85 tons of CPO in September. In trying to hedge his
exposure, he should SHORT 3 contracts of October CPO futures at RM2,897/ton. The
calculation of the number of contracts is as follows:

Number of contracts = Exposure / Contract Size

= 85 tons / 25 tons
= 3.40 contracts
= 3 contracts (round-down)

The choice of the October CPO futures contract is because his exposure will be until 20th
September. If he takes the September contract, the contract will expire on 15th of
September, leaving his exposure unhedged for 5 days. Therefore, it is more rational to
take the October contract where he can close it out prior to expiry on 20th September
2004.

There are two types of mismatch present here:

1) Maturity mismatch
2) Quantity (Contract size) mismatch.

Question 4

The cost of carry model:

Fair price =2000(1+0.04+0.04)^3/12=2038 vs. 2200 (Futures are overpriced). Short
futures & long spot