Chapter 7

 UNIT TRUSTS AND

FINANCIAL DERIVATIVES

ROSLINA BT AMEERUDIN
Med (technical), BBA (Hons) Finance,
Dip. In Banking
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Course Outline
7.1 Ascertain the concept of unit trust

7.1.1 Define unit trusts

7.1.2 Identify the types of Unit Trust

7.1.3 Explain the structured in operation of unit trust

a. Trust deed

b. Trustee

c. Management company

d. Investors or unit holders

e. Securities Commission
 7.1.4 List the advantages and disadvantages of unit trust
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7.2 Discuss the derivatives market

7.2.1 Explain the types of derivatives market in
Malaysia
a. Futures
b. Forward
c. Option
7.2.2 Identify the advantages of derivatives market
7.2.3 Explain the history of derivatives market in
Malaysia
7.2.4 Explain the Malaysia Derivatives Exchange
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Definition Unit Trust

 an organization which takes money from small investors and invests it

in stocks and shares for them under a trust deed, the investment
being in the form of shares (or units) in the trust
 

A unit trust fund is made up of equal shares which are

called “units”; these “units” have a price called a Net
Asset Value (NAV). 

Individual invest in a unit trust fund, the fund itself is run by a fund
manager, whose aim is to grow the overall value of unit trust fund. 
The fund manager does this by investing the fund's assets, usually
by buying stocks, bonds, or a combination of these two securities
which are listed on the Stock Exchange. 
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 Unit Trusts are a form of collective investment that allows

investors with similar investment objectives to pool their
funds to be invested in a portfolio of securities or other
assets.
 A professional fund manager then invests the pooled
funds in a portfolio which may include the asset classes
listed below:
 Cash
 Bonds & Deposits
 Shares
 Properties
 Commodities
 
Types of unit trusts
1. Income Funds
The portfolio included in income funds are usually high quality bonds
and stocks that yield consistent dividends.
The investment strategy is to provide investors with regular
and stable income.
The risk involved in such funds is relatively lower compared to that
of the growth funds.

2. Growth Funds
The investment strategy of growth funds is to focus on securities that
have high prospects for capital gains and growth potential.
As such, the risk involved is relatively higher compared to that of the
income funds.
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3. Aggressive Growth Funds
The aggressive growth fund is one that centres its portfolio on
risky securities in firms or industries that have possibility of high
growth rates and high returns.

4. Balanced Funds
The balanced funds invest in securities that have a balance
between income funds and growth funds with a maximum of 60
percent investment in equities and the balance in fixed interest
securities.
The balanced fund has a more diversified portfolio compared to
the income fund and growth fund. Since this fund is a “balance”
between the income fund and the growth fund, generally the return
and risk are more moderate.
 
5. Islamic Funds
The investment strategy of Islamic funds is to invest only in shares
and fixed income securities that are halal and the fund has to be
managed in accordance with Syariah principles.
6. Bond Funds
The focus of bond funds is on fixed income securities or bonds.
The risk involved is lower than that of the income and growth funds
as the risk associated with bonds is lower than that of equity.
7. Index Funds
The investment strategy focuses on a portfolio that places emphasis
on growth and the portfolio is one that matches the KLSE Composite
Index.
This fund is more interested in long term capital appreciation and
future gains rather than current income.
 Structured
 in operation of unit trust

a. Trust deed

-Trusts are created by a legal document called “trust deed”

-Prepared by a solicitor which outlines the purpose of the
trust, the rights and obligations of the trustees and unit
holders, powers of the trustee, and identifies various parties
such as initial unit holders & Trustee(s).
 
Structured in operation of unit trust

b. Trustee
-The role of trustee is to safeguard the interest of unit
holders, distribute income and ensure that the manager
keeps to the fund’s objective.
-The fund’s assets are held by the trustee and the trustee
received all income from those assets.
-Trustee has to obtain approval from the Securities
Commission in order to act as trustee of the fund.
 Structured
 in operation of unit trust

c. Management company
-A unit trust scheme is managed and administered by a
managerial company approved by the Security Commission.
-The role of unit trust management companies is to manage
the operation of funds aiming to make a profit.
-The relationship between the unit trust management
company and the investors is governed by the deed.
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Structured in operation of unit trust
d. Investors or unit holders
-Unit holders invest in the fund on the basis of the
prospectus.
-Have the right to the trust assets. Their right and
liabilities are defined in the deed and prospectus.
-Unit holder cannot take part in the management
decisions of unit trust.
 Structured in operation of unit trust


e. Securities and exchange commission

-Established on 1 March 1993 under the Securities Commission
Act 1993.
-Self-funding statutory body with investigative and enforcement
powers.
-It has the power to investigate and enforce the areas within its
jurisdiction.
-The SC is a self-funding organization where its income is derived
from the collection of levies and application fees.
-Regulating all matters relating to unit trust schemes.
 Advantages
 of investing in unit trusts

1. Benefits of Diversification

 A unit trust is an investment scheme that pools funds

from individual investors and invests these funds in a
range of securities or assets.
 When an investor purchases shares in a unit trust, he
or she is purchasing a part of the portfolio of the
investment scheme.
 Even though the investor has limited capital, the risk
can still be diversified with the formation of a portfolio
in the unit trust scheme.
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2. Liquidity

A unit trust can be considered a liquid asset as trading

of shares in unit trust can be done in organized
exchanges similar to that of the common shares
exchange.
Alternatively one can sell back the units to the
investment company, depending on the type of funds,
whether it is closed-end funds or open-end funds.
Since unit trusts are liquid assets and can be
converted into cash easily
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3. Management of Funds by Professionals and
Experts

Small investors who do not possess financial

knowledge on investments and/ or do not have the time
to keep track or analyze the equity market, may find the
unit trust an attractive investment alternative.
Unit trusts offer a cheap alternative for small investors
to enjoy the professional expertise of fund managers.
4. Simple
 and Easy to Invest

Unit trust firms are geographically dispersed thus

making it easy for investors to purchase their shares.
Commercial banks in Malaysia with their large network
of branches have their line of unit trust funds, thus
making it easily available to the public.
 Besides this, the amount required to invest in unit
trust is quite small and purchase can also be done
easily through unit trust agents..
 
Disadvantages of investing in unit trusts

1. Unit trusts are generally medium to long-term

investments, which may not suit all investors. ·
2. The volatility in the investment, as prices fluctuate
daily according to market movements, may not suit all
investors’ needs.
3. Investors can be tempted to redeem their unit trusts
in the short-term.
4. Because professionals administer unit trusts, there
are certain costs involved.
 Considerations

in selection of unit trusts

1. Objectives

 This is a rather personal consideration as two

investors may have different needs and different risk
appetites.
 For example, investor A, a retiree, who stresses on
a regular and stable income may choose for the
income funds whereas investor B who is young,
aggressive and willing to take higher risk may
choose to invest in growth funds or aggressive
growth funds.
 

2. Fund Managers and Track Record of

Fund’s Performance

It is important for an investor to know the fund

manager and find out the track record and
performance of the funds in previous years.
Unit trust companies always give a word of
caution whereby investors are encouraged to
read the prospectus before investing.
 
FINANCIAL DERIVATIVES

The word “derivative” gives the idea that

something is derived from something. Basically,
a financial derivative refers to :
a contract made between two parties and the
derivative’s product value is derived from the
value of an underlying asset such as share
prices or indices, interest rates, commodity
prices such as crude palm oil, etc.
 
Futures Contract and Forward Contract

 A futures contract refers to an agreement made

between two parties to buy or sell a specified asset at
a specified date in the future.
 Delivery is in the future but the specified price is fixed
now or today.
 The futures markets are organised markets as these
markets are governed by certain rules and
regulations regarding the future months, e.g. 3
months, 6 months, 9 months, the units or size of
transactions, the currency used etc.
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 A forward contract refers to an agreement between

two parties to buy or sell a specified asset at a future
date.
 The price is normally determined now or today.
However, it is different from a futures contract as this
instrument is traded in an unorganised market.
 There are no fixed rules regarding the number of
months, units of transactions, etc. It has a higher
counter party risk or default risk.
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Types of Futures Contract

Short Position (seller)
An agreement to sell an asset at a specified future date
at a specified price. It commits a trader to deliver an item
at contract maturity.

Long Position (buyer)

An agreement to purchase an asset at a specified future
date at a specified price. It commits a trader to purchase
an item at contract maturity.
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Function
 Futures Contract and Forward
Contract

1. Hedgers
Buy or sell futures contracts in order to offset the risk in a cash
position.
How to hedge :_
i. The short (sell) hedge

A cash market inventory holder must sell (short) the futures to

protect the value of their assets. Investors are holding the
securities, they are long in cash position and need to protect
themselves against a decline in prices.
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ii. The long (buy) hedge

An investor who currently holds no cash inventory

(holds no commodities or financial instruments) is short
in the cash market. Therefore to hedge requires a long
futures position. By establishing a long position today,
the investor makes a commitment to buy in the futures
at a price determined today.
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2. Speculators

 Speculators buy or sell futures contracts in an

attempt to earn a return.
 They are willing to assume the risk of price
fluctuations, hoping to profit from them.
 They contribute to the liquidity of the market and
reduce the variability in prices over time.
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3. Cash market

It is a typical trading for physical commodities and financial

instruments. A cash contract means calls for immediate
delivery and is used by those who need a commodity now. A
cash contract cannot be canceled unless both parties agree.
 
Spot market is a market where current market price of an
item available for immediate delivery.
Forward market is a market for deferred delivery.
Forward price is the price of an item for deferred delivery.
Compare
 futures contract and forward
contract

 While futures and forward contracts are similar in

terms of their final results, a forward contract
does not require that the parties to the contract
settle up until the expiration of the contract.
 Settling up usually involves the loser (i.e., the
party that guessed wrong on the direction of the
price) paying the winner the difference between
the contract price and the actual price.
 

Options

Definition :
An option refers to a contract whereby the buyer is given the
right or privilege to purchase or to sell an underlying asset at a
specified price. However, the buyer of the rights may choose
to forgo the rights to exercise the option.

Example of a market where options are traded is the Kuala

Lumpur Composite Index (OKLI) Options.
There are two types of options a buyer can purchase:
(a) Call Options
(b) Put Options
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Types of option

1. Call option
An option to buy a specified number of shares at a
stated price within a specified period of months.

2. Put option
An option to sell a specified number of shares at a
stated price within a specified period of months.
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 Investors purchase calls if they expect the share price

to rise. Therefore calls permit investors to speculate
on a rise in the price of the underlying share without
buying the share itself.

 Investors purchase puts if they expect the share price

to fall. Therefore puts allow investors to speculate on
a decline in the share price without selling the share
short.
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 The call option gives the buyer the right to buy

the underlying asset at a specified price (exercise
price or strike price) at a specified time period.
 If the buyer fails to exercise the rights within the
given time period, the rights would become null
and void.
 The exercise price or strike price is the price that
a buyer pays to purchase the underlying asset.
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
 The Put Options

 The buyer of the put option is given the right to sell

the underlying asset at a specified price (exercise
price or strike price) at a specified time period.
 The exercise price or strike price is the price that a
buyer of the put option would have to sell the
underlying asset.
 However to acquire the rights for a call or put option,
a buyer has to pay a premium, that is the price of the
rights.
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Terminology:-

 Exercise (strike ) Price

The per share price at which the common share may be
purchased from or sold to a writer.

 Expiration Date
The last date at which an option can be exercised.

 Option Premium
The price paid by the option buyer to the seller of the option.
 How options work

 The buyer and the seller have opposite expectations about the
likely performance of the underlying share and therefore the
option itself.

 The call writer expects the price of the share to move down. The
call buyer expects the price of the share to move up.
 
 The put writer expects the price to move up. The put buyer
expects the price to move down.
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
The styles of the options

 American Style
The option can be exercised any time before the expiration date.

 European Style
The option can only be exercised on the expiration date.
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
Relationship between the exercise price of
the option and the current stock price 

 Exercise price – E
 Current stock price – S

 For a call option ; If :-

 S > E – The option is in the money.

 S < E – The option is out of the money
 S= E the option is at the money.
40

 For a put option; If :-

 S < E – The option is in the money.

 S > E – The option is out of the money

 S= E the option is at the money

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ADVANTAGES OF DERIVATIVES MARKET

 Since all transactions related to derivatives take place in future, it

provides individuals with better opportunities because an individual
who want to short some stock for long time can do it only in futures or
options hence the biggest benefit of this is that it gives numerous
options to an investor or trader to execute all sorts of strategies.

 In derivatives market people can transact huge transactions with small

amounts and therefore it gives the benefit of leverage and hence even
people who have less amount of money can enter into this market.
 
ADVANTAGES OF DERIVATIVES MARKET

 Intraday traders get the benefit of liquidity as these

contracts are very liquid and also the costs such as basis
expense, brokerage are less as compared to cash market.

 It is a great risk management tool and if applied

judiciously it can produce good results and benefit its user.
 History derivatives in Malaysia
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Preferred Shares
Definition

Preference share is an equity security with an

intermediate claim on a firm’s assets and earnings It
is a hybrid security because it resembles both fixed-
income and equity instruments. It is more income
oriented than capital gains-oriented.
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
Characteristics of Preferred Shares

a. Limited ownership rights. i.e no voting rights.

a. Fixed dividend
Annual dividend payments are fixed at a certain percentage of the
par value of the shares.

b. Dividend priority over ordinary shares.

Fixed dividends are paid before dividends are paid to ordinary
shareholders.

c. Priority in asset claims.

Referred as senior securities. In the case of the liquidation of the
company preference shareholders have a prior claim on the
company’s assets over the ordinary shareholders.
52

Types
 of preferred stocks

1. Cumulative preference shares.

Unpaid dividends may accumulate as dividends in
arrears before any dividends can be paid to the ordinary
share holders.

2. Redeemable or callable preference shares.

It can be redeemed or recalled by the company. The
investors will receive a pre-determined sum of money,
usually includes any unpaid dividends.
53

3. Convertible preference shares.

It gives the holder the privilege to convert it into
ordinary shares at specified prices. It gives
advantage to the share holder when the market
price of ordinary shares increases.

4. Participating preference shares.

It gives its owner the right to share both the
fixed dividend and earnings of the company after
all senior securities have been paid.
 
TERMS ASSOCIATED WITH
PREFERRED STOCKS

1. Par Value
The par value is the selling price or issue price per share of the
preferred stock when it is first sold to the public.

2. Cumulative Feature
The cumulative feature attached to preferred stocks implies that if the firm
cannot pay dividends to its preferred stockholders during a particular year, this
dividend would be accumulated to the following year.
This cumulative feature is included to make the preferred stocks more
attractive to investors.
 

3. Call Feature
A call feature included in the issuance of preferred stocks
allows the issuing firm to “call”
or redeem the preferred stocks at a specified
price
•Reason is to take advantage of the low market interest
rates.
•However, this call feature would be a disadvantage to
preferred stockholders. Thus in order to compensate them,
the firm would have to pay a “call premium” whereby the call
price would have to be higher than the selling price of the
stock.
 ADVANTAGES
 AND DISADVANTAGES OF
PREFERRED STOCKS

 Advantages

(a) Payments of dividend are not legally binding

 If the firm incurs losses, it is not required to pay dividends
to its preferred stockholders.
 In the case of bonds interest payments are compulsory
regardless of whether the firm
 earns profits or incurs losses. The firm would not be sued
over non-payment of dividends to preferred stockholders.
 
(b) Increase in earnings per share

Since the dividend for preferred stock is usually fixed

at the issuance of the shares, the earnings after
deduction of preferred stock dividend would be
considered as earnings available to shareholders.
Thus during good times when earnings are high, the
firm would be able to record an increase in earnings
per share thereby boosting its performance.
 
Disadvantages

(a) Higher after-tax cost as compared to

debt security
 Interest payments on debt security are tax
deductible whereas dividend payments on
preferred stock are not.
 As a result, the after-tax cost of using
preferred stock may be higher than after-
tax cost of debt to the firm.