BFW2751 Derivatives 1

S1, 2022
Lecture Week 1:
Mechanics of Futures Market
Chapters 1 and 2 in main reference book
Learning Objectives
1. To understand what, how and where are the derivatives markets
2. To understand basics of Futures, Forward, Options and SWAP contracts
3. To focus into Mechanics of Futures Contracts and it’s Trading
4. To demonstrate how Futures contracts transactions works
5. To differentiate between Futures and Forward contracts

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 What are derivatives?
• A financial contract written on an underlying asset price, that its value depends on (or
derived from) other, more fundamental, variables which has an active secondary market,
such as :-
• A single stock price
• A stock market index for a portfolio of stock funds
• A foreign currency exchange rate
• A commodity price
• An interest rate / interest rate index
• Or even the price of another derivative security
• Or even the amount of snowfall in a skiing region
• Or even the box office revenue of a movie
• The underlying driving variable is commonly referred to as the underlying asset.
• An investor may or may not own the underlying asset in order to buy or sell a derivative
instrument.

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Basic requirements for a derivative
 Derivative is a paper contract to exchange either cash or the underlying asset itself on a future
specified maturity date.
 Derivative must be written on a reference underlying asset that is actively traded in a secondary
market.
 The value of the derivative depends on the price movement of the underlying asset which it refers
to. Owning a derivative does not mean you own its underlying asset.
 Just like any other investment asset, an investor can buy or sell a derivative instrument based on
his / her requirement.
 As it is a paper contract that has a variable value at any given point of time, all derivatives will
have a definite maturity date that expires the contract i.e. 1 month, 3 months, 6 months or even 1
year cycle.

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 Types of derivative contracts
1) The Forward contracts: bilateral agreement between a seller (in short position) and a buyer (in long position); is the
simplest and traditional of all derivative contracts; mostly traded in a over-the-counter (OTC) market; customized and
have default risk. An agreement to transact an asset on a forward date at the price fixed today. Most of the time the
underlying asset is delivered or exchanged at the maturity of a forward contract.

2) The Futures contracts: real hedge instrument; to buy or sell assets through a futures exchange market; contracts are
highly standardized; default risk protected by margin mechanism. Futures market exists side by side to the spot or cash
market. Almost any asset that has an active secondary market will be listed in the futures market. Most of the time
futures contracts are closed off before the maturity date and offset for exchange of cash instead of taking delivery of the
underlying asset.

3) The Options contracts: a financial insurance; to cover price variations with an agreed strike price through an option
seller for an upfront fee / price known as premium.

4) The Swaps contracts: bilateral contracts to exchange cash-flows at stipulated future dates typically the earnings /
interest rate on an investment or borrowing.

5) We will learn the detained characteristics and mechanics of trading on each type as we get into the topic.

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 Who and why use derivatives?
 Used by: hedgers, speculators, and arbitragers.
 Types of Traders
1) Hedgers use it to minimize or neutralize losses against underlying asset price movement risks.
Hedging means to transfer the risks of adverse price movement to another party.
2) Speculators use derivative contracts to make profit against future price movements of
underlying assets by taking the risk of losses if price movements are adverse.
3) Arbitragers use it to lock in a guaranteed profit at zero risk based on the mispricing of same
asset in two different markets.
 Basically to create a safety net against unanticipated adverse movements of the underlying asset
prices.
 To change the nature of an investment without incurring the costs of selling one portfolio and
buying another to protect the fund value.

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 A Conceptual Example on Forward Contract
• Gold is not a derivative. It is a commodity with a unit price determined in the gold market that has
uncertain price movements. However, gold price can be used as an underlying since it has a secondary
market daily spot price variation.

• Consider the following forward contract:

• On September 10, a buyer and seller enter into a forward contract to trade in 100 oz. of gold in 3 months (i.e. on
December 10) at an agreed price of $1000 /oz.
• That is, the seller is undertaking to sell 100 oz. of Gold in 3 months at an agreed price of $1000 /oz. while the
buyer is undertaking to buy 100 oz. of Gold at $1000/oz. (This is a bilateral agreement between two parties in
an OTC market). Total contract value is 100 x 1000 = $100,000.
• Consider two possible outcomes of Gold price on December 10:
• a) What if the spot price of gold on December 10, turns out to be $1200 /oz.?
• b) Alternatively, if the spot gold price on December 10 is $850 /oz. ?

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A Conceptual Example on Forward Contract
Payoffs of this Gold Forward contract on December 10:
Scenario a):
If the spot price of gold on December 10, turns out to be $1200 /oz., the payoff is $200/oz. for the buyer and -
$200/oz. for the seller (in total the buyer in long forward position gains $20,000, while the seller in short
position loss $20,000).
Scenario b):
Alternatively, if the spot gold price on December 10 is $850 /oz., the buyer loses $150/oz. whilst the seller gains
$150/oz. (in total the buyer will lose $15,000 and the seller will gain $15,000)
Once a forward contract is agreed with a fixed delivery price, that price becomes the obligated price on the
delivery date (immaterial of the spot price on the maturity date).
• Generally, forward contracts creates certainty of cash flows at the maturity date. The outcome of the spot
price of gold (in this case) is just a comparable opportunity cost / gain.
• We apply this concept to all forward contracts on any underlying asset for all maturities.

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 Why trade on derivatives?
• In the previous example, the buyer of gold may be a jeweller who need to buy gold in December but is
concerned that gold prices may rise:  hedging
• Think how selling / buying gold forward can be a hedging transaction?
• Alternatively, a trader may merely think the gold price in December will be considerably higher than the
current $1000/oz.:  speculation
• Another, less known reason is arbitrage: The seller, for example, may be certain that the forward gold
price quoted in the market may be too high compared to the current spot price they are able to trade,
(plus other considerations), thus trying to exploit this mispricing.
• Yet another reason is market making: the buyer or seller could be a financial institution serving their
customer, and wish to earn a spread between the buying and selling price for a given maturity.

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How derivatives are traded ?
1. On Exchange Traded Markets such as the Chicago Mercantile Exchange (CME), NYSE, ASX,
and so on.
2. In Over-The-Counter (OTC) Market, where traders representing investment banks, fund
managers and corporate treasurers contact each other directly to trade derivative instruments on
daily basis.
 In Malaysia we have the BMD (Bursa Malaysia Derivatives)
 Categories of Derivatives Traded:
1) Commodity Derivatives
2) Equity Derivatives
3) Financial Derivatives

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Exchange Trade vs OTC
• Exchange Traded Derivatives • OTC Traded Derivatives

E
• Asset X Asset
C
Direct Dealing
A H B
• $ $ A B
A
N
G
E
• The Exchange Market regulates the sale and purchase
as well as the payments
• Seller and Buyer deal directly
• The Exchange Market acts as an intermediary to
eliminate default risks in the transaction • No intermediary to regulate
• Some default risk persist

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Size of Global Derivatives Market
• https://www.bis.org/statistics/rpfx19.htm?m=6_32_617
• The gross market value of over-the-counter (OTC) derivatives increased by $300 billion to $15.8 trillion
during the second half of 2020, led by increases in foreign exchange (FX) derivatives. The sizeable US
dollar depreciation against major currencies is likely to have contributed to the rise.

• https://www.isda.org/a/tBngE/Key-Trends-in-the-Size-and-Composition-of-OTC-Derivatives-Markets-
in-the-First-Half-of-2021.pdf

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Futures Contracts
• Just as it is named upon, futures contracts are derivatives on any underlying asset that trades in its listed futures exchange market
based on its futures contract floating price. (not fixed price)
• Futures exchange market exists side by side to the corresponding assets spot market, however the futures contract drawn upon an
asset will have its floating futures price moving along with the spot price of its underlying asset based on its maturity horizon.
• Futures contracts normally has its maturity dates as 1-month futures, 3-month futures, 6-month futures and 1-year futures written
on any listed underlying asset.
• Futures contract price on an asset is determined by its contract month’s demand and supply on the number of contracts being
held by counterparties called number of open interest.
• Futures contracts are highly standardized in terms of Quantity, Quality, Size and Maturity (Q/Q/S/M).
• The contract specifications of an underlying asset may vary between one market to another market.
• Futures contracts are recognized by its underlying asset and its maturity horizons.
• E.g. Crude Palm Oil Futures (FCPO) contracts mature in the Spot month and the next 11 succeeding months, and thereafter,
alternate months up to 36 months ahead.
• A September FCPO contract means that this future contract expires in the month of September and its price is specified
according to that particular contract maturity.

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Typical Example of a FCPO
• FCPO
Contract Specifications

Contract Code FCPO

Underlying Instrument Crude Palm Oil

Contract Size 25 Metric Tons (MT)

Contract Months Spot month and the next 11 succeeding months, and thereafter,
alternate months up to 36 months ahead
Pricing Unit Malaysian Ringgit (MYR)

Final Settlement Physical Delivery

• Copy and paste the URL to read more on FCPO prices

• https://www.bursamalaysia.com/market_information/derivatives_prices?
sort_by=cumulative_vol&sort_dir=desc

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FCPO Prices
Prices in RM Per Metric Ton as on 12th July 2021
Name Month Open Settle Open Interest
1 FCPO July 2021 3,985.00 3,989.00 2,238
2 FCPO Aug 2021 4,001.00 3,909.00 18,932
3 FCPO Sept 2021 3,954.00 3,863.00 74,162
4 FCPO Oct 2021 3,883.00 3,806.00 40,995
5 FCPO Nov 2021 3,808.00 3,756.00 32,905
6 FCPO Dec 2021 3,751.00 3,708.00 20,276
7 FCPO Jan 2022 3,712.00 3,662.00 12,431
8 FCPO Feb 2022 3,669.00 3,623.00 12,395

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Futures Trading Mechanism
Exchange Traded
 All futures contracts are traded through Futures Exchange Market (FEM).
 The FEM plays the role of an intermediary and the clearing house.
 As an intermediary the FEM discovers the futures prices of an underlying for the contract expiry months
and connects the counterparties instantaneously.
 As a clearing house, the FEM guarantees the counterparties against default risks through a Margin
mechanism.
 Margin is a cash or marketable securities provided as collateral by both the counterparties to the FEM.
 The gain / loss of a contract is tracked and settled every day via marking-to-market (daily rebalancing)
mechanism on a daily basis. Margin are like our e-wallets that stores cash for designated purposes.
 These margins are to ensure funds are available to pay traders when they make a loss, hence protecting
the clearing house and the futures market as a whole.
 Traders do not have to hold the futures until maturity. In fact it is more common that they close out /exit
prior to maturity.

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Trading Positions in Futures Market
• Long Futures Position: Is to buy futures contract on a selected underlying asset now and to sell it on or
before maturity of the contract.
• If an investor is bullish about the underlying asset price in a specified contract time, this investor will take a
long position to gain profit on speculation of the raising price of the asset within the contract expiry time.
• Therefore, Long Futures Position: Buy now and sell later.
• Short Futures Position: Is to sell futures contract on a selected underlying asset now and buy back on or
before the maturity date of the contract. (also called Short Selling)
• If an investor is bearish about the underlying asset price movement in a specified contract time, he/she will
take a short position to gain profit on speculation of the falling price of the asset within the contract expiry
time.
• Therefore, Short Futures Position: Sell now and buy back later.
• The Buyer and Seller of the same futures contract is know as Counterparties to each other.
• The counterparties may not know each other and they are matched or paired by the Futures market.

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Margins in Futures contracts
• Margin Mechanism

Counterparty A Counterparty B
In Long Position In Short Position

Initial margin is about 5% of

Initial Margin $
To the brokers
the total contract value

Maintenance Margin
Throughout the contract life Maintenance margin is about
75% of the Initial margin

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Margins in Futures contracts
• Margin is like a wallet created with the futures brokers to hold a sum of cash or near cash
instruments to receive profits or to pay losses.
• Both counterparties must contribute the specified Initial margin (IM) to open a contract and must
maintain a specified % of Maintenance Margin (MM) throughout the life of the contract.
• The IM amount is about 4 to 5% of the total contract value as the daily contract price may vary
within this percentage.
• The MM must be always set at 75% of the IM value at all days throughout the contract life.
• What happens when the MM threshold is breached on any trading day?
• The party in deficiency must replenish the margin to its IM level within the next trading day.
• Failing to replenish the margin will lead to confistication of the contract be by the broker to offer it
to any other interested party.
• Therefore, futures contract margin is the mechanism set by futures market to protect the
counterparties from default risk and to uphold the integrity of the futures market.

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Some terminology in Futures Contracts
 Open interest: the total number of contracts outstanding : equal to number of long
positions and short positions in trade
 Settlement price: the price just before the final bell each day used for the daily
settlement process
 Volume of trading: the number of trades in one day
 Short Selling: Selling something that you don’t own. Short selling is common in Futures
market where the party in short position sells a certain number of contracts on an
underlying asset with an agreement to buy back on or before the maturity of the contract.
 Long Position: To buy now and sell later to reverse the contract (close out)
 Short Position: To Sell now and buy back later to reverse the contract (close out)

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 A Conceptual example of futures contract trade
• On 5th March 2022, an investor takes a long position (buys) on Five September 2022 Gold futures contracts:
• Contract size is 100 oz./contract. ( 5 contracts will be 500/oz.)
• Gold Futures price on 5th March 2022 is US$1250/oz. ( Total contract value = 5 x 100 x 1250 = $625,000)
• Initial margin requirement is US$6,000/contract (US$30,000 in total)
• Maintenance margin is US$4,500/contract (US$22,500 in total)
• The contract is closed out on 7th trading day at a closing price of $1,245.00 / oz.
• When the margin balance falls below the maintenance margin of $22,500 the margin has to be replenished back
to the initial margin value.
• The margin balance is rebalanced each day at the close of the trading day.
• The gaining party’s margin will receive the daily gain from the losing party’s margin. This transfer and balance
management is conducted by the futures market managers.

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Daily settlement of Long Futures trade transaction

Price/Oz Total Daily Cumulative

Day ($) Settlement Contract Value Gain / Loss Gain / Loss Margin Margin Call
    Price / Oz ($) ($) ($) ($) Balance ($)  

1 1,250.00 625,000.00   30,000.00  No

1   1,241.00 620,500.00 -4,500.00 -4,500.00 25,500.00  No
2   1,238.00 619,000.00 -1,500.00 -6,000.00 24,000.00  No
3   1,236.00 618,000.00 -1,000.00 -7,000.00 23,000.00  No
4   1,229.00 614,500.00 -3,500.00 -10,500.00 19,500.00 10,500.00

   Margin is replenished to its original IM level 30,000.00  

5   1,232.00 616,000.00 1,500.00 1,500.00 31,500.00 No 
6   1,248.00 624,000.00 8,000.00 9,500.00 39,500.00 No 
7   1,245.00 622,500.00 -1,500.00 8,000.00 38,000.00 No 
  Total Gain / Loss  -2,500.00 -2,500.00  

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Closing out of a futures contract
 Closing out a futures position involves entering into an offsetting trade position
 Most futures contracts are closed out before maturity
 In the gold futures example, closing out on Day 7 involves long trader entering in to a short
position on the Five December gold futures contracts
 Key Points About Futures
 They are settled daily (by rebalancing respective margin accounts of the counterparties)
 Closing out a futures position involves entering into an offsetting trade
 Most contracts are closed out before maturity date.
 95% of the futures contracts are offset by not taking delivery of the underlying asset.
 Only about 5% of the futures contracts are settled through physical delivery.

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So really what is a Futures contract trade?
• It is a bet on the price / value of some underlying asset in the future contract maturity date.
• Unlike the bets you typically see like horse racing which settles the bet once the race finished,
futures trade is an ongoing floating prices that can be closed out anytime before the maturity.
• The gain/loss from the bet in a futures trade is tracked and settled every day via marking-to-
market concept.
• The ability to close out before maturity also means that you do not have to deliver or take delivery
of the underlying asset.
• This also means that futures markets, originally designed to help businesses hedge risk, can
become a casino (which I am not saying a bad thing) for speculative purposes.

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 Futures Contract Settlement
 Most of the contracts are closed out before maturity and they are cash settled (daily transferred from
counterparty’s margin account)
 If a futures contract is not closed out before maturity, it is usually settled by delivering the underlying
asset in the contract. (it can be Physical settlement or Cash settlement)
 When there are alternatives about what is delivered, where it is delivered, and when it is delivered,
generally the party with the short position chooses.
 The exchange specifies the exact range of dates during which delivery can take place. Trading
generally ceases before the last day on which delivery can take place.
 A few contracts (for example, those on stock indices like SPI futures and Eurodollars) are settled in
cash

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Futures Price converges to Spot price at Maturity
• Provided the asset being hedged and the future contract is same in terms of specifications, the futures price and the spot price
of the asset should converge at the contract maturity point.
• The futures price may be higher or lower than the spot price of the underlying asset at the inception of the futures contract
(which is called Basis) should be same at the contract maturity.

Price Price
FP SP

SP FP

t0 T1 Time t0 T1
Time
The Futures Price is higher than Spot Price at t 0, The Spot Price is higher than Futures Price at t 0

Converges to FP = SP at T1 Converges to SP = FP at T 1

• The condition is that both the hedged asset and the hedging futures should be on the same underlying asset, expiring on same
maturity and have same quantity.

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Forward vs. Futures contracts
 Both are agreements to buy or sell an asset for a price at a certain future date.
 A forward contract is traded in the OTC (Over‐The‐Counter) market, not at an exchange-traded
market.
 There is no daily settlement in a forward contract as gain or loss is settled at the maturity

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Forward Contracts vs. Futures Contracts

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Lecture Summary
• Key points about futures
 Futures contracts are agreements between parties with obligations to buy / sell certain underlying
assets at a future maturity date at a future market price on or before the expiry of the contract
date.
 Gains and losses are settled daily based on the closing price in the futures market of the specified
underlying asset.
 Closing out a futures position involves entering into an offsetting trade position.
 Most contracts are closed out before maturity.

End of Lecture 1
 Next week: Hedging strategies using futures.
 Read chapter 3 before the lecture and complete tutorial questions.

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