Futures, Hedging & Commodity

Trading at NCEL

ICAP

Karachi
Thursday, May 13, 2004
Agenda
• Derivatives
• Forwards & Futures
• Hedging Strategies
• Futures Exchange – An antidote
to WTO
• NCEL
• Q&A
The Nature of Derivatives

A derivative is an instrument whose

value depends on the values of other
more basic underlying variables
Examples of Derivatives
• Forward Contracts
• Futures Contracts
• Swaps
• Options
 Derivatives Markets
• Exchange traded
– Traditionally exchanges have used the open-
outcry system, but increasingly they are switching
to electronic trading
– Contracts are standard
– There is virtually no credit risk as exchanges are
CCP’s
• Over-the-counter (OTC)
– A computer- and telephone-linked network of
dealers at financial institutions, corporations, and
fund managers
– Contracts can be non-standard and
– There is credit risk (counterparty risk)
Ways Derivatives are Used

• To hedge risks
• To speculate (take a view on the
future direction of the market)
• To lock in an arbitrage profit
• To change the nature of a liability
• To change the nature of an investment
without incurring the costs of selling
one portfolio and buying another
 Forward Contracts

• A forward contract is an agreement to buy

or sell an asset at a certain time in the future
for a certain price (the delivery price)
• It can be contrasted with a spot contract
which is an agreement to buy or sell
immediately
• It is traded in the OTC market
 Forward Price
• The forward price for a contract is the
delivery price that would be applicable
to the contract if were negotiated
today
• The forward price may be different for
contracts of different maturities
Foreign Exchange Quotes for
GBP/US$ on Aug 16, 2003

Bid Offer
Spot 1.4452 1.4456
1-month forward 1.4435 1.4440
3-month forward 1.4402 1.4407
6-month forward 1.4353 1.4359
12-month forward 1.4262 1.4268
 Example
• On August 16, 2001 the treasurer of a
corporation enters into a long forward
contract to buy £1 million in six months at
an exchange rate of 1.4359
• This obligates the corporation to pay
$1,435,900 for £1 million on February 16,
2002
 Futures Contracts
• Agreement to buy or sell an asset for a
certain price at a certain time
• Similar to forward contract
• Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange
• Virtually no credit risk as the exchange is a
CCP
Other Key Points About Futures

• Standardized contract
• Quality is pre-defined and permissible variation
is settled through premium or discount
• Requires a margin prior to taking a position
• They are settled daily – marked to market
• Variation margin is payable in cash only
• Closing out a futures position involves entering
into an offsetting trade
• Most contracts are closed out before maturity –
98%
 Forward Contracts vs Futures
Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at maturity Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Examples of Futures Contracts

• Agreement to:
– buy 100 oz. of gold @ US$300/oz.
in December (COMEX)
– sell £62,500 @ 1.5000 US$/£ in
March (CME)
– sell 1,000 bbl. of oil @ US$20/bbl.
in April (NYMEX)
 What Determines Basis ?

As basis reflects local market conditions it

is directly influenced by several factors
such as :
• Interest / Storage Costs
• Transportation costs
• Local supply and demand conditions
• Handling Costs
 Basis Terminology

Gold spot Rs 7,200

November Futures Rs 7,220
Basis - Rs 20 Nov

The basis is “20 under November”

 Basis Terminology

Gold spot Rs 7,200

November Futures Rs 7,180
Basis Rs 20 Nov

The basis is “20 over November”

 Strengthening Basis

If the spot price increases relative to the futures

price, or the difference between the spot price
and futures price becomes less negative (or
more positive).

A strengthening basis works to a sellers

advantage.
 Weakening Basis

If the spot price decreases relative to the futures

price, or the difference between the spot price
and futures price becomes more negative (or less
positive).

A weakening basis works to a buyers advantage.

 Convergence of Futures to Spot

Basis = S – F
p p

B<0 B>0

F P
S P

S P
F P

Time Time

(a) (b)
 Gold: An Arbitrage
Opportunity?
• Suppose that:
- The spot price of gold is US$300
- The 1-year forward price of gold is
US$340
- The 1-year US$ interest rate is 5%
per annum
• Is there an arbitrage opportunity?
(We ignore storage costs)?
 The Forward Price of Gold
If the spot price of gold is S and the forward
price for a contract deliverable in T years is F,
then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S = 300, T = 1, and r =0.05 so
that
F = 300(1+0.05) = 315
Oil: An Arbitrage Opportunity?

Suppose that:
- The spot price of oil is US$19
- The quoted 1-year futures price of
oil is US$25
- The 1-year US$ interest rate is
5% per annum
- The storage costs of oil are 2%
per annum
• Is there an arbitrage opportunity?
 Delivery
• If a contract is not closed out before maturity, it
usually settled by delivering the assets underlying the
contract.

• When there are alternatives about what is

delivered, where it is delivered, and when it is
delivered, the party with the short position chooses.

• A few contracts (for example, those on stock indices

and Eurodollars) are settled in cash
 Delivery Instruments

• Vault Receipts are used for the delivery of precious

metals and certain financial instruments. E.g. Gold

• Warehouse Receipts are used with delivery of grain.

E.g. Wheat

• Demand Certificates are used with delivery of

perishables.
 Margins
• A margin is cash or marketable securities
deposited by an investor with his or her
broker
• The balance in the margin account is
adjusted to reflect daily settlement
• Margins minimize the possibility of a loss
through a default on a contract
 How Margins Work ?
• An initial margin must be deposited at the
time the contract is entered
• Margin account is “marked to market” on
a daily basis i.e. adjusted to reflect the
investors gain or loss – direct debit
• The investor is entitled to withdraw any
balance in the margin account in excess
of the initial margin – in case of NCEL we
will pay only if requested
 How Margins Work ?
• To ensure a certain minimum balance in margin
account a maintenance margin is set.
• If margin account balance falls below the
maintenance margin, the investor receives a
margin call and is expected to top up the
account to the initial margin level the next day
• Spot month margins will be required in the
delivery month
• Delivery margin, which could be as high as
25%
 How Margins are Determined ?
• Initial margin is based on a scientific risk
management methodology called Value at Risk
(VaR)
• VaR is a method of assessing risk that uses
standard statistical techniques routinely used in
other technical fields.
• Methodologies such as variance/covariance,
EWMA, historical simulation, etc.
• Formally, VaR measures the worst expected loss
over a given time interval under normal market
conditions at a given confidence level
• Exchanges use SPAN, TIMS, PRISM, etc.
Value-at-Risk
 Gold Prices
Gold price, US$ per ounce, London pm fix

450

400

350

300

250

200
Jan-00 May-00 S ep-00 Jan-01 May-01 S e p-01 Jan-02 May-02 S e p-02 Jan-03 May-03 S ep-03 Jan-04
 Sigma = 2 VaR @ 99%
7 .0 0 0 0 %

6 .0 0 0 0 %

5 .0 0 0 0 %

4 .0 0 0 0 %
S e rie s1
S e rie s2
3 .0 0 0 0 %

2 .0 0 0 0 %

1.0 0 0 0 %

0 .0 0 0 0 %
 Sigma = 4 VaR @ 99%
10 .0 0 0 0 %

9 .0 0 0 0 %

8 .0 0 0 0 %

7 .0 0 0 0 %

6 .0 0 0 0 %

S e rie s1
5 .0 0 0 0 %
S e rie s2

4 .0 0 0 0 %

3 .0 0 0 0 %

2 .0 0 0 0 %

1.0 0 0 0 %

0 .0 0 0 0 %
 Example of a Futures Trade
• An investor takes a long position in 2
December gold futures contracts on June
5
– contract size is 100 oz.
– futures price is US$400
– margin requirement is US$2,000/contract (US$4,000
in total)
– maintenance margin is US$1,500/contract
(US$3,000 in total)
A Possible Outcome

Daily Cumulative Margin

Futures Gain Gain Account Margin
Price (Loss) (Loss) Balance Call
Day (US$) (US$) (US$) (US$) (US$)

400.00 4,000
5-Jun 397.00 (600) (600) 3,400 0
. . . . . .
. . . . . .
. . . . . .
13-Jun 393.30 (420) (1,340) 2,660 + 1,340 = 4,000
. . . . . .
. . . . .
. . . . . . < 3,000
19-Jun 387.00 (1,140) (2,600) 2,740 + 1,260 = 4,000
. . . . . .
. . . . . .
. . . . . .
26-Jun 392.30 260 (1,540) 5,060 0
Futures Market
 Futures Exchange
• Contracts are standardized
• Trading is centralized
• Market-making is competitive
• Third-party guarantee of contract
performance
• Do not have to borrow or own
underlying to short sell
• Trading is certificateless
• Low transaction costs
 How Do Derivative Contracts
Improve Market Operations?
• Aid in price discovery and serve as a
reference point
– Participants attracted to markets
– Additional resources spent on information
collection and analysis
– Arbitrage between markets transmits the
new information throughout the complex of
markets
 "Forward Looking" Prices
• Futures prices are estimates of future cash
prices
• Price basing refers to the practice of using
futures prices as a base or reference point
for other transactions
 Do Futures Stabilize Cash
Prices?
• Investment is encouraged because of low
transaction costs
• Investors are likely to drive prices to levels
justified by economic fundamentals
• Volatility in futures and options prices
transmitted to cash by arbitrage
• Removes distortions and fragmentation
 How Do Derivative Contracts Improve
Market Operations?
• Facilitate the exchange of risk across
market participants
– A commercial risk is transferred to
someone more willing to bear the risk
– Exchange-traded futures facilitate trade
between strangers
– May improve the liquidity of underlying
cash markets
 Wheat Price Comparison between Major &
Minor Pakistani Markets
(For Three Years)
1000

900

800
Sowing
Rupees/100 Kg

Sowing Harvesting
Harvesting Sowing
700
Harvesting

600
Red = Average of Three Major Markets
Yellow = Average of 9 minor Markets

500

2000-01 2001-02 2002-03

400

Source: Federal Bureau of Statistics

Hedging
 Types of Traders

• Hedgers
• Investors
• Arbitrageurs
Some of the large trading losses in
derivatives occurred because individuals
who had a mandate to hedge risks switched
to being speculators
 Long & Short Hedges
• A long futures hedge is appropriate when
you know you will purchase an asset in
the future and want to lock in the price
• A short futures hedge is appropriate
when you know you will sell an asset in
the future & want to lock in the price
Arguments in Favor of Hedging

• Companies should focus on the main

business they are in and take steps to
minimize risks arising from interest
rates, exchange rates, and other market
variables
 Choice of Contract
• Choose a delivery month that is as close
as possible to, but later than, the end of
the life of the hedge
• When there is no futures contract on the
asset being hedged, choose the contract
whose futures price is most highly
correlated with the asset price.
 Hedging
Strategy to reduce risk of future price volatility
• e.g., suppose you (a garment manufacturer)
signed a contract to sell jeans over 1 year at
a fixed price
– options:
• buy all denim cloth requirements now
– need storage space; have to incur carrying cost
• buy yarn futures contracts with delivery dates spread
out through out the year
 Hedging Examples
• A garment exporter will receive $1
million for exports to the US in 3 months
and decides to hedge using a short
position in a forward contract
• A yarn manufacturer imports machinery
for $1 million for which payment will be
made in 6 months will use long position
in a forward contract
 Yarn – Price Correlation
10/1 16/1 21/1 26/1 30/1
800
700
600
Monthly Avg Yarn Prices

500
400
300
200
100
-

Source:Aptma Website
NCEL: An antidote to WTO
 Textiles - End of Quotas!
• Sudden drop in protection after 50 years
• Production and market share is unfrozen
• Quota holding is no longer passport to Western
Markets
• Market share will be gained through international
competitiveness
• More players leads to falling prices
• “There is always someone cheaper”
• Hedging platform is a necessity for the value
added textile sector
Price Trend
Cotton Prices
Cotton Prices
Exchange Rates
 Percentage Change of Average Monthly Yarn
prices of 21/1
40%

1M 3M 6M
30%

20%
%age Change

10%

0%

-10%
2000-01 2001-02 2002-03 2003-04

-20%

-30%

Source: Aptma Website

NCEL: An Antidote to WTO
• Platform for hedging – lock in prices
• Will allow manufacturers to manage raw
materials price-risk – in case of textile
related industries it is as high as 80%
• Exporters can enter into longer term
contracts
• Less chances of reneging on contracts
• Overall, has a smoothening effect on prices
• Positive impact on employment and poverty
alleviation
NCEL
 Background
• NCEL established on April 20, 2002
• Permission granted by SECP on May 16, 2002
• Present Shareholders
– KSE-40%
– LSE-10%
– ISE-10%
– Pak Kuwait Investment Co. – 10%
– Zarai Taraqiati Bank Ltd. – 10%
• Paid-up-Capital Rs.40 million (post ZTB)
• Additional FI participation (20%) being
considered
• Authorized Capital Rs.50 million
 Highlights
• First de-mutualized exchange in Pakistan
• First fully integrated electronic exchange
capable of also handling financial futures
• First to employ modern risk management
techniques – Value-at-Risk
• First to introduce the concept of “The Central
Counterparty”
• First to introduce Vault Receipts and
Warehouse Receipts – negotiable instruments
• First to develop a “Spot Yield Curve” for the
market
 Key Drivers for Success
• Provide a transparent platform for easy and
equal access for all participants
• Trading Regulations will provide complete
confidence and protection to investors
and users
• Risk Management, and Surveillance &
Monitoring will be based on the
international “Best Practices”
• Developing thoroughly researched
contract specifications
 Target Market
• GDP - Rs4,042 billion (2002-03)
• Agriculture contributes 24 % - Rs970 billion
• Share of major crops 9.6% - Rs388 billion
• Textiles represent 10.5% - Rs424 billion
• Crude oil & oil products imports - Rs156
billion
• Palm oil imports - Rs26 billion

“Internationally the multiple for cash

versus futures is 5-70 times”
 Vision/Mission
FROM TO
• Price distortions • Observable future prices
• Wide spreads or one way • Narrow spreads and two way
quotes quotes
• Absence of • Quality certification &
standardization standardization
• Counterparty risk • Risk mitigation
• Impediments in financing • Ease in financing
• Price manipulation • Price dissemination

“To provide an opportunity to the farmers to

farm for the market”
 NCEL Buyer
NCEL Business Process NCEL Seller

Orders Orders
Order Routing

Rejected Orders Rejected Orders

Accepted Orders
Pre-Trade
Risk Checks Central Order Book

Cancelled/Expired Orders Cancelled/Expired Orders

Order Matching

Matched Order (Trade)

On a daily basis
Upon expiry Clearing & Settlement
of contract
Settlement Price
Delivery Order Rate Computation

Mark-to-Market
Contract Maturity
Processing Post Trade Risk
Checks
Settlement Payments
Delivery Orders Receipt Margins
Delivery Allocation Variation Margins Fee
Delivery Margins Online Bank
Quality & Quantity Transfers
Certification
Each matched order has a
buyer and a seller
Warehouses Clearing Banks
 Contract Development
Seed Cotton

Ginning Textiles Process

Lint Cotton

Weaving
Spinning Yarn Processing Apparel &
Garments
Knitting

Syn. Fibre
 Price Trend of Pakistani Wheat
(For Three Cropping Seasons)

900

850
Rupees/100 Kg

800
Ha
rv
Sowing Period e st i
ng
Pe
750 rio
d

700

2000-01 2001-02 2002-03

650
Oct Nov Dec Jan Feb Mar Apr May
Source: Federal Bureau of Statistics
*Prices are the Average of 12 Pakistani Markets
 Agriculture Sector
• Tenant farmers do not have access to
organized financial sector
• Borrows from unorganized sector at rates
as high as 120% per annum
• Forced to sell immediately upon harvest –
no holding power
• Compromise on inputs – low yield per acre
• Lack of infrastructure – warehousing
• Middleman provides a one stop shop!
 Commodity Based Financing
• Structured form of financing with an
objective of transferring risk from an entity
to a commodity
• In discussion with a NGO to undertake
financing as a pilot project on the following
basis :
1. Pre-sowing for inputs against NCEL
contract (short) and social collateral
2. Post-harvest and upon storage against a
warehouse receipt
 Financing Mechanism
Entire profits go to the
farmer if NGO manages
Farmers price risk using NCEL Middleman

Middleman effectively
eliminated from process
Cash
Crop
Seeds
Other NGO views futures prices at
inputs
NCEL and enters into a contract

Warehouse Receipt

NGO NCEL
Cash
 360° Company Update
• Hardware and software has been installed
• Software is being configured
• Gold and Cotton Yarn contract specifications
are being developed
• Regulations are being refined and have to be
approved by the Board and SECP
• 95% hiring is complete
• Online bank transfer arrangements are being
finalized with MCB
 360° Company Update Cont’d….

• Vault arrangements are being finalized

with KASB Bank Ltd.
• Mock trading will begin by 24/5/04
• “ZCYC”, “Cotton Farmers & Ginners ROI”,
“Wheat Farmers ROI”, etc. White Papers
are being prepared and will be presented,
shortly
• Rice and Wheat contracts are being
developed for next season
 360° Company Update Cont’d….

• Staff is highly educated and experienced

in trading futures, risk management, IT,
investment banking, agriculture, textiles,
financial mathematics, corporate &
securities law, stock-broking, accounting,
tax, etc……
• “Go Live” when Members are ready
Order & Trade Confirmation Process
 Classification of Risk
• Credit Risk
• Liquidity Risk
• Settlement Risk
• Market Risk
• Operational Risk
• Legal Risk
 Risk Mitigation Strategies
• Clearing Limits – Members
• Position limits – Members & Clients
• Initial & Maintenance Margins
• Variation Margin – daily MTM
• Additional Margin in the spot month to
ensure convergence
• Standard NCEL approved
documentation
 Risk Mitigation Strategies Cont’d…

• Security Deposit
• Clearing Limit – Members
• Initial Margin – Members & Clients
• Pre-Trade Check
• Segregation
• Bank Accounts – Members & Clients
• Sub-accounts at CDC
• Mark-to-market daily settlement - online
• Position Limits – to counter manipulation
 Margining
• Example - Gold
– Clearing Deposit: Rs1.5 million = 4%
– Initial Margin: Rs0.5 million = 4%
• Initial Margin: 99% VaR over 1 day
• Spot Month Margin: 99% VaR over 10 days
• Delivery Margin: 99% VaR over 3 days
 Market Surveillance
• Apart from legal requirements, NCEL will
demonstrate self-regulatory presence as it
is just good business practice ….
• We must win confidence of participants
and demonstrate that there is integrity in
our market
• Must protect investors in our marketplace
 Market Surveillance Cont’d…

To identify situations that could pose a threat to

manipulation and to initiate preventive action by
monitoring:
a. Large traders
b. Key price relationships
c. Supply and demand factors
d. Spot market activities
Zero Coupon Yield Curve (ZCYC)
• Also known as the Spot Yield Curve
• NCEL will use ZCYC for calculating theoretical
futures price
• ZCYC can be used to price wide range of
securities including coupon paying bonds,
derivatives, FRAs and swaps
• NCEL is estimating ZCYC using primary market
data for Government securities
• Can also be used to price non-sovereign fixed
income instruments after adding in credit
spreads
Thank You