INTRODUCTION• Derivatives – Defined as securities whose values are determined by the market price of some other assets. – Financial instruments used to manage ones exposure to todays volatile markets. – Products value depends upon and is derived from an underlying instrument such as commodity prices, interest rates, indices, and share prices.
PURPOSES OF DERIVATIVES• Risk Management - Reducing the risk in holding a market position while speculation referred to taking a position in the way the markets will move that enable companies to more effectively manage risk.• Price discovery - Futures market prices depend on a continuous flow of information from around the world and require a high degree of transparency that impact supply and demand of assets and thus the current and future prices of the underlying asset on which the derivative contract is based.
ROLES OF DERIVATIVES• Provide global diversification in financial instruments and currencies.• Help hedge against inflation and deflation.• Generate returns that are not correlated with more traditional investments.• Allow fast product innovation because new contracts can be introduced rapidly and can be tailored to the specific needs of any user
MAIN PLAYER IN DERIVATIVES MARKETS• Hedgers: They are the players whose objective is risk reduction.• Arbitrageurs: They are the players whose objective is to profit from pricing differentials/mispricing.• Speculators: They are the players who establish positions based on their expectations of future price movements.
POSITION OF DERIVATIVES• Long position – Purchase an asset due to the price will increase in the futures.• Short position – Sold an asset due to the price will fall in the future.
TYPES OF DERIVATIVES1. SWAP – Transaction between 2 parties simultaneously exchanges cash flow on the national amount of asset. – Example: counterparty A agrees to pay a fixed rate interest payment to counterparty B in exchange for variable interest rate payment form counterparty B. – Types of swaps: • Interest rate swaps • Currency swaps
TYPES OF DERIVATIVES2. OPTIONS – A contract between 2 parties in which one party (buyer) has a right but Not the obligation to buy or sell a specified asset at a specified at or before specified date from other party (seller). – Features of option contract: i. Type of option whether call or put, ii. State the underlying asset, iii. Exercise price or strike price iv. Maturity or expiration date v. Exercise style, whether American or European style.
• Types of options: – Call option An option that the holder the right but not the obligation to buy the underlying asset at a predetermined price. • Long – Price will increase (bullish). • Short – Price will decrease (bearish). Example: If an investor expects the price of RM 12 shares to rise (bullish), they might pay RM0.20 for a three month call option that gives them the right to buy those shares for RM 12 at a later date.
• Put options An option that the holder the right but not the obligation to sell the underlying asset at a predetermined price. • Long – Investor expects price will decrease. • Short – Investor expects price will increase. Example: If the market will be bullish so investor A decide to sell a put to investor B for RM0.15 that gave investor B the right to sell the shares at RM 12. If the stock rises in value to RM 14, what is the payoff?
• Option Strategies have three types: Straddle - Buy / sell call and put with the SAME strike price and expiration date. Strangle - Buy / sell a call and put with SAME expiration date but DIFFERENT strike price. Spread - Take a position option either 2 call or 2 put in different strike price. Bull – expect a stock price will be increase. Bear – expect a stock price will be decline.
TYPES OF DERIVATIVES 3. FUTURE & FORWARD – A contract between 2 parties that has right and obligation to buy the underlying asset at predetermine price. FUTURES FORWARDMethod of trading Per electronic trading system Over the counter or by through a central exchange telephoneContract size Standardized - type and quality of Negotiated to suit the underlying asset, terms of individual needs contract, method of settlement and price determination.Delivery date Standardised on a specific date for Negotiated to suit certain contracts individual needs
Futures ForwardsIntegrity of system and Guaranteed by the clearing Dependent on the riskpayments house of the central relating to the individual exchange parties to the contractRegulation Regulated by law, statutory No formal regulation body and exchangeTradability Traded in secondary markets No secondary market for these contractsSecurities and Security deposits to be No formal security unlessprotection of parties lodged with the exchange at agreed by parties to the closing of contracts, and contract daily cash settlements for fluctuations in prices
COMMODITY FUTURES Contract Code FCPOUnderlying Crude Palm OilInstrumentContract Size 25 metric tonsMinimum Price RM1 per metric tonFluctuationContract Months Spot month and the next 5 succeeding months, and thereafter, alternate months up to 24 months ahead
EQUITY FUTURES Contract Code FCPOUnderlying FTSE Bursa Malaysia Kuala Lumpur CompositeInstrument Index (FBM KLCI)Contract Size FBM KLCI multiplied by RM50Minimum Price 0.5 index point valued at RM25FluctuationContract Months Spot month, the next month and the next two calendar quarterly months. The calendar quarterly months are March, June, September and December.