Chapter 1 (overview of derivatives)


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Chapter 1 (overview of derivatives)

  1. 2. WHAT ARE DERIVATIVES? <ul><li>Derivatives are financial instruments whose value is derived from an underlying physical commodity or financial instrument </li></ul><ul><li>Example: </li></ul><ul><li>Price that is derived from the price of the instrument on which they are based such as : </li></ul><ul><li>crude palm oil futures are based on the price of palm oil traded in the commodities market, while stock index options are based on the FTSE Bursa Malaysia KLCI (FBMKLCI). </li></ul>
  2. 3. CONCEPT OF DERIVATIVES <ul><li>A contract to buy and sell which is set today but will be fulfilled at a stipulated date later. </li></ul><ul><li>Derivatives products are financial instruments available to corporation and investor for the purpose of managing their exposure to financial markets’ volatility. </li></ul><ul><li>A derivative instrument’s value is derived from the value of some other more basic underlying instrument such as commodity prices, exchanges rates, interest rates and share prices. </li></ul>
  3. 4. CASH MARKET VS. DERIVATIVES MARKET <ul><li>CASH MARKET </li></ul><ul><li>Is the market for immediate delivery of and payment for commodity or financial instruments. </li></ul><ul><li>DERIVATIVES MARKET </li></ul><ul><li>Delivery of and payment for commodity of financial instruments will be made in the future. </li></ul>
  4. 5. TYPES OF DERIVATIVE MARKETS <ul><li>FUTURES </li></ul><ul><li>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. </li></ul><ul><li>Each contract specifies the commodity, the quantity, quality and time of delivery or cash settlement. </li></ul>
  5. 6. <ul><li>OPTIONS </li></ul><ul><li>An option provides the holder/buyer the right, but not the obligation, to purchase or sell a certain quantity of the underlying instrument at a stipulated price within a specific time period by paying a premium. </li></ul><ul><li>The seller of the options, has an obligation, which is activated if the buyer exercises that right. </li></ul>
  6. 7. BENEFITS OF DERIVATIVES <ul><li>Managing the risk associated with holding the underlying asset position </li></ul><ul><li>Portfolio asset allocation purpose </li></ul><ul><li>Income generation through taking a position in these products </li></ul>
  7. 8. THE EXCHANGE <ul><li>An exchange is a specific market place where derivatives are originated and traded. </li></ul><ul><li>Provides trading environment </li></ul><ul><li>Servers as communication centers, centralizing orders from various buyers and sellers and disseminating relevant information on price. </li></ul><ul><li>It is also self regulatory organization where it establishes rules governing: </li></ul>
  8. 9. <ul><li>Membership to the Exchange </li></ul><ul><li>The administration of the Exchange </li></ul><ul><li>Member & customer relationships </li></ul><ul><li>Trading practices </li></ul>
  9. 10. EXCHANGE TRADED VS. OVER THE COUNTER (OTC) DERIVATIVES <ul><li>Differences between exchange traded market & OTC </li></ul>FEATURES OTC EXCHANGE TRADED Market Place Not Centralized Centralized Regulation Self-regulated Commission-regulated Trading Negotiated contract Standardized contract Margins payment No legal requirement Legal requirement Credit/ Default risk High Low Transparency No Yes Guarantee performance No Guaranted by clearing house
  10. 11. <ul><li>Development of Derivative Market in Malaysia </li></ul><ul><li>(Find it by yourself & please submit ) </li></ul>
  11. 12. CLEARING HOUSE <ul><li>The clearing house that clears the contracts traded in MDEX is known as the Malaysian Derivatives Clearing House Bhd (MDCH) which is managed independently from the exchange. </li></ul><ul><li>The primary function of a clearing house is to provide financial stability by guaranteeing the performance of all contracts traded. </li></ul>
  12. 13. <ul><li>Essentially, it acts as the counter party to all contracts traded by assuming the obligation of a buyer to the original seller and of a seller to the original buyer. </li></ul><ul><li>Novation- Is the substitution of the clearing house for the opposite contracting party in a futures or options contract. Through novation, the clearing house becomes the buyer to every seller and the seller to every buyer. </li></ul>
  13. 14. <ul><li>Responsible for all settlement procedures arising from options and futures trading. </li></ul><ul><li>The role of the clearing house can be summarized as follows: </li></ul><ul><li>It provides central clearing-ensuring all members fulfills their obligation. </li></ul><ul><li>It acts as a central bank to all exchange members by matching all trades transacted on the exchange </li></ul><ul><li>It sets margin levels and handles movement in margin requirement </li></ul><ul><li>It takes the responsibility of good delivery of each contract, thereby guaranteeing trades. </li></ul>
  14. 15. INTERMEDIARIES IN BM DERIVATIVES <ul><li>FUTURE BROKERS </li></ul><ul><li>Conduct a futures broking business, act as intermediaries between the clients and Exchange in a marketplace </li></ul><ul><li>They can trade on behalf of clients. </li></ul><ul><li>Basic function: </li></ul><ul><li>Represent their customers in placing orders in the market </li></ul><ul><li>Collecting margins from the customers </li></ul>
  15. 16. <ul><li>Providing basic accounting records </li></ul><ul><li>Advising customers in their trading programs </li></ul><ul><li>FUTURE TRADING ADVISORS </li></ul><ul><li>Act as adviser to the investors on futures trading. </li></ul><ul><li>Can be companies or individuals. </li></ul><ul><li>Major difference between the futures trading advisers & future brokers is that future trading advisers cannot conduct business as a broker and are not direct members of the Exchange. They play an advisory role to the customers who are interested in participating in the futures & options market. </li></ul>
  16. 17. FUTURE FUND MANAGERS <ul><li>A person who carry out a future fund management business. </li></ul><ul><li>Specialize in managing funds that trades in future & options </li></ul><ul><li>Employees of futures fund managers are called futures fund manager representative </li></ul>
  17. 18. USERS OF FUTURES & OPTIONS <ul><li>HEDGERS </li></ul><ul><li>Hedgers are investors or fund managers who will trade future contracts to hedge their portfolio exposure from any unexpected price movement in the underlying or related market. </li></ul><ul><li>Their primary interest is to protect the value of their portfolio </li></ul>
  18. 19. <ul><li>SPECULATORS </li></ul><ul><li>Individuals who trade future contracts with the primary interest of profiting from the future market </li></ul><ul><li>Willing to assume the risk of price fluctuations & hope the profit. </li></ul><ul><li>The presence of speculators contribute significantly to the liquidity of the market. </li></ul>
  19. 20. <ul><li>Arbitragers </li></ul><ul><li>People who engage in arbitrage activities </li></ul><ul><li>Involves locking in a risk –less profit by simultaneously trading in two or more markets </li></ul><ul><li>Take advantage of relative price disparity between two related markets. </li></ul>