CHAPTER 2

CONCEPTS OF DERIVATIVES
1. Definition of Derivatives
2. Types of Derivatives
3. Purpose of Derivatives Markets
4. Major participant
5. Exchange-Traded VS Over-the-Counter
6. Origin and Growth of Derivative Trading
7. The Structure and Development of the
Derivative Market in Malaysia
DEFINITION OF DERIVATIVES
 Derivatives are financial instruments whose
value is derived from its underlying assets.
(Securities Commission, 2002)

 Derivative can be defined as a financial

instrument whose value depends on or derives
from values of other assets. (Hull, 2003).
TYPES OF DERIVATIVES
 Contract or agreement to buy and sell asset at the
future

 Price + asset+ delivery date = agreed today

 Forward
 Forward is an agreement to buy and sell a specified security
at a specified price to be delivered at the maturity date in the
future

 agreement is privately arranged to fulfill the need of both

contracting parties, a buyer and seller

 If one party intends to close-out the contract, it must be at

the consent of the other party

 is technically referred to as a privately-negotiated agreement

 Futures
 It is a legally binding agreements between two parties to buy or
sell an asset at a certain time in the future for a certain price.
(Hull, 2003).

 A futures contract is an agreement between two parties to buy or

sell the underlying instrument at a specific time in the future for a
specific price determined today. (Bursa Malaysia, 2009)

 develops as a result of insufficient trading requirement of forward

transactions (Private agreement)
 Futures
 A third party is required to act as the guarantor, namely
the clearing house

 Clearing House serves as a buyer for every seller, and

vice versa
 FORWARD CONTRACT
BUY
BUYER SELLER
SELL

FUTURES CONTRACT
BUY BUY
CLEARIN
BUYER SELLER
SELL G HOUSE SELL
Features FOWARD FUTURES/ OPTION
Market place Not centralized Centralized
Regulation Self-regulated Commission-regulated
Trading Negotiated contract Standardized Contract
Transparency Not transparent Transparent
Margins payment No legal requirement Legal requirement
Credit/Default risk High Low
Guarantee of No guarantee of Guaranteed by
Performance performance clearinghouse
 Options
 It is a contract which provides the holder/buyer the
right, but not the obligation, to purchase or sell a certain
quantity of the underlying asset at an agreed price
within a specific time period by paying a premium to
the issuer/seller of the option contract. (Bursa Malaysia,
2009)

 provides a right to one party and an obligation to the

other party
 BUYER OF SELLER OF
CONTRACT CONTRACT
FUTURES/FOW OBLIGATION OBLIGATION
ARD

OPTION RIGHT OBLIGATION

CALL TO BUY TO SELL

PUT TO SELL TO BUY

 Swap
 A private agreement to swap or exchange a specified
security or specified cash flow

 The swap transaction generally arises due to the need of

international businesses between two countries

 By trading procedure, swap is very similar to forward as

both markets are not regulated.
PURPOSE OF DERIVATIVES MARKETS
 Derivatives market serves to provide 2 basic
economic functions:

 price discovery

 hedging mechanism
 The ability of the derivative markets to reveal information about
future cash market prices
 The revealing of information represents the consensus of participants
today about the prices of a physical instrument in the future
 Therefore, investors can easily discover the likely price in the future
by referring to the derivative price today
 Investors may have reference prices that could be used by them to
enter or exit the market freely and easily
 This price discovery – will also enable investors to make better
investment & consumption decisions about their exposure in the
physical markets
 Maybank declare profit 1st Quater

Futures market Spot Markets Market

Buy 1000 share futures at Buy 1000 shares at price

price RM10 margin RM1 RM10

Pay RM1000 Pay RM10000

Acc: 1000 shares futures worth Acc:1000 shares worth
RM10000 RM10000

Demand increase, Price futures

increase
Demand
increase, price share increase
 Participants in the futures market use derivative contracts as a
substitute for the cash market transaction.

 Physical owners of a commodity use derivatives instruments to manage

their price risks systematically.

 Price risks refer to the adverse price movements in the future that will
affect their exposure in the cash market

 a seller will "sell" futures today in anticipation of "falling" prices, while

a buyer will "buy" futures today in anticipation of "rising" prices
MAJOR PARTICIPANT
 Participants of a derivative market could be
broadly categorized into:
 Hedgers

 speculators
 Hedgers are physical owners of the underlying commodity
who will use derivative instruments to protect their risk
exposure in the cash market

 This is possible because of the economic function of a

derivative market to provide a hedging mechanism for
hedgers

 Hedgers will use derivative market as a forum for

managing unfavorable price movements
 Speculators, on the other hand, are traders who are attracted to
the market in view of profiting from the volatility of prices
 This is justifiable because they have to assume the price risk
that hedgers seek to avoid.
 They are exposed to high risk in view of their position as long-
term traders who normally hold derivative contracts for more
than one week.
 Their risk exposure, however, depends on their objective of
holding which is detailed in the next chapter, such as spreaders
and arbitrageurs.
EXCHANGE-TRADED VS OVER THE COUNTER
 Derivative instruments, like ordinary shares –
always traded through an organized exchange

Features Over-the-Counter Exchange-Traded

Market place Not centralized Centralized
Regulation Self-regulated Commission-regulated
Trading Negotiated contract Standardized Contract
Transparency Not transparent Transparent
Margins payment No legal requirement Legal requirement
Credit/Default risk High Low
Guarantee of No guarantee of Guaranteed by
Performance performance clearinghouse
ORIGIN AND GROWTH OF DERIVATIVE TRADING
 Derivative trading – originated formally from forward
transactions
 History – 12th Century in Europe – during the era of the
Industrial Revolution
 During this period –merchants forward their goods well
before these goods arrived at the designated ports
 Since prices were settled at the time the agreement was
reached, both buyers & sellers are protected against
adverse price movements
 The 1st organized futures trading took place in Japan in
the 18th Century – which tickets were issued for
entitlement of rice crops in the field
 The trading was organized because merchants would buy
these tickets based on their future needs of rice
 The existence of the organized futures market were
reinforced by the introduction of the date of delivery,
grades and quantity of rice & more importantly, the
formation of the first clearing house to act as a guarantor
by issuing the tickets
THE STRUCTURE AND DEVELOPMENT OF THE
DERIVATIVE MARKET IN MALAYSIA
 The Malaysian derivative regulatory structure
 Ministry of Finance – the controller

 Securities Commision – the regulator

 Bursa Malaysia Derivative Berhad (BMDB) – the operator of the exchange

 Bursa Malaysia Derivatives Clearing (BMDC) – the clearing house

 Malaysia joined the derivative trading community – the launch of crude palm
oil futures traded at KLCE – Oct 1980
 Thereafter, KLCE also trades the other national agro-based commodities – tin
& cocoa
 For this reason – KLCE was named the 1st South-East Asian multi-commodities
futures trading in 1991
 In December 1995 – Malaysia became the 1st nation outside Japan to
trade the local-based index with the trading of Kuala Lumpur Composite
Index (KLCI) futures at the Kuala Lumpur Options & Financial Futures
Exchange (KLOFFE)

 In May 1996 – Kuala Lumpur Inter Bank Offer Rates (KLIBOR) –

launched at Malaysia Monetary Exchange (MME)

 In Dec 1998 – KLCE & MME merged to form the Commodities and
Monetary Exchange (COMMEX)

 In May 2001 – KLOFFE & COMMEX merged to form a single

derivative market known as the Malaysia Derivative Exchange (MDEX)
 In March 2002 – MDEX launched the first bond futures contract
based in ringgit on the Malaysian Government Securities (MGS)

 The Malaysian derivative markets today – have a single

derivative exchange (BMDB), with a single clearing house
(MDCH) and a sole-regulator (SC) for all derivatives trades

 In 2005 – MDEX is now known as Bursa Malaysia Derivatives

Berhad (BMDB), and MDCH as Bursa Malaysia Derivatives
Clearing (BMDC) Berhad