Derivatives are financial instruments whose value is derived from an underlying asset such as a commodity, bond, or equity. There are two main types of derivatives - futures contracts, which are agreements to buy or sell an asset in the future at an agreed upon price, and options contracts, which give the holder the right but not the obligation to buy or sell the underlying asset. Derivatives markets allow participants to manage risks and generate income associated with changes in prices of the underlying assets. Exchanges facilitate trading of standardized derivatives contracts and provide clearing houses to guarantee the performance of all contracts.

2. WHAT ARE DERIVATIVES? Derivatives are financial instruments whose value is derived from an underlying physical commodity or financial instrument Example: Price that is derived from the price of the instrument on which they are based such as : 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).

3. CONCEPT OF DERIVATIVES A contract to buy and sell which is set today but will be fulfilled at a stipulated date later. Derivatives products are financial instruments available to corporation and investor for the purpose of managing their exposure to financial markets’ volatility. 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.

4. CASH MARKET VS. DERIVATIVES MARKET CASH MARKET Is the market for immediate delivery of and payment for commodity or financial instruments. DERIVATIVES MARKET Delivery of and payment for commodity of financial instruments will be made in the future.

5. TYPES OF DERIVATIVE MARKETS FUTURES 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. Each contract specifies the commodity, the quantity, quality and time of delivery or cash settlement.

6. OPTIONS 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. The seller of the options, has an obligation, which is activated if the buyer exercises that right.

7. BENEFITS OF DERIVATIVES Managing the risk associated with holding the underlying asset position Portfolio asset allocation purpose Income generation through taking a position in these products

8. THE EXCHANGE An exchange is a specific market place where derivatives are originated and traded. Provides trading environment Servers as communication centers, centralizing orders from various buyers and sellers and disseminating relevant information on price. It is also self regulatory organization where it establishes rules governing:

9. Membership to the Exchange The administration of the Exchange Member & customer relationships Trading practices

10. EXCHANGE TRADED VS. OVER THE COUNTER (OTC) DERIVATIVES Differences between exchange traded market & OTC 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

11. Development of Derivative Market in Malaysia (Find it by yourself & please submit )

12. CLEARING HOUSE 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. The primary function of a clearing house is to provide financial stability by guaranteeing the performance of all contracts traded.

13. 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. 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.

14. Responsible for all settlement procedures arising from options and futures trading. The role of the clearing house can be summarized as follows: It provides central clearing-ensuring all members fulfills their obligation. It acts as a central bank to all exchange members by matching all trades transacted on the exchange It sets margin levels and handles movement in margin requirement It takes the responsibility of good delivery of each contract, thereby guaranteeing trades.

15. INTERMEDIARIES IN BM DERIVATIVES FUTURE BROKERS Conduct a futures broking business, act as intermediaries between the clients and Exchange in a marketplace They can trade on behalf of clients. Basic function: Represent their customers in placing orders in the market Collecting margins from the customers

16. Providing basic accounting records Advising customers in their trading programs FUTURE TRADING ADVISORS Act as adviser to the investors on futures trading. Can be companies or individuals. 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.

17. FUTURE FUND MANAGERS A person who carry out a future fund management business. Specialize in managing funds that trades in future & options Employees of futures fund managers are called futures fund manager representative

18. USERS OF FUTURES & OPTIONS HEDGERS 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. Their primary interest is to protect the value of their portfolio

19. SPECULATORS Individuals who trade future contracts with the primary interest of profiting from the future market Willing to assume the risk of price fluctuations & hope the profit. The presence of speculators contribute significantly to the liquidity of the market.

20. Arbitragers People who engage in arbitrage activities Involves locking in a risk –less profit by simultaneously trading in two or more markets Take advantage of relative price disparity between two related markets.