CHAPTER 8

1
Objectives
Definition and purpose of derivatives
market
Derivative instruments
Exchange-traded versus over the-
counter derivatives
Market players and institutions

2
Introduction
Transactions in the market:
Spot transactions
Delivery happens on the spot
Forward transactions
Delivery happens sometimes in the future but
the price and quantities are determined today

3
Introduction
Derivatives are instruments created to
minimize risk
Their value are derived from something
From an asset
Example: share prices, prices of commodity,
indices and interest rates
Commodity derivative if the underlying assets
are commodities such as palm oil, coffee, wheat
etc.
Financial derivative if the underlying assets are
financial assets such as debt instruments,
currency, share price etc.

4
Introduction
Definition:
Derivative instruments are simply financial
instruments which have values determined
by prices of the underlying assets
Their values depend on prices of underlying
assets
3 main derivative instruments:
Futures
Forwards
Options
5
History of Derivatives
Started as early as 1848 in the US
Mainly concentrated in the commodity market
1919 the establishment of Chicago Mercantile
Exchange (CME), providing futures contract on various
commodities
Later, New York Mercantile Exchange and Chicago Board
Options Exchange were developed
Financial derivatives began to dominate trading during the
1970s
In the early 1980s, most of the financial futures were
traded in US
But later, in the mid1980s to 2003, new exchanges were
developed throughout Europe, South America and Asia
Pacific region

6
The link between the development of
derivatives market and price variability
of financial instruments is natural
A need to manage the risk
7
History of Derivatives
The Development of Malaysian
Derivatives Market
From 1980 1995, our derivatives market was
confined mainly on the crude palm oil (CPO) futures
traded on the Kuala Lumpur Commodity Exchange
(KLCE)
In 1995 Kuala Lumpur Options and Financial
Futures Exchange (KLOFFE), now known as Bursa
Malaysia Derivatives Berhad (BMD) which is 75%
owned subsidiary of Bursa Malaysia Berhad. 25%
owned by CME. It provides, operates and maintains
a futures and options exchange.
BMD operates the most liquid and successful crude
palm oil futures contract in the world
On 15 Dec 1995, the first financial futures contract
based on the KLSE CI was traded on KLOFFE
8
May 1996 Malaysia Monetary Exchange (MME)
was set up to provide fixed income derivatives,
namely 3-month KLIBOR futures contract
In 1998 KLCE + MME = COMMEX (Commodity
and Monetary Exchange of Malaysia)
Jan 1999 KLOFFE became the subsidiary of KLSE
June 2001 KLOFFE + COMMEX = Malaysian
Derivatives Exchange (MDEX)
MDEX was renamed Bursa Malaysia Derivatives
Berhad on 20 April 2004
9
The Development of Malaysian
Derivatives Market
BMD operates under the supervision of
SC and is governed by the Capital
Market and Services Act 2007
On September 17, 2009, BMD entered
into a strategic partnership with Chicago
Mercantile Exchange
10
The Development of Malaysian
Derivatives Market
Derivative Products Traded on
BMD
http://www.bursamalaysia.com/market/derivatives/

BMD has the following products available to be traded on the CME Globex

electronic
trading platform

Commodity Derivatives
Crude Palm Oil Futures (FCPO)
USD Crude Palm Oil Futures (FUPO)
Crude Palm Kernel Oil Futures (FPKO)

Equity Derivatives
FTSE Bursa Malaysia KLCI Futures (FKLI)
FTSE Bursa Malaysia KLCI Options (OKLI)
Single Stock Futures (SSFs)

Financial Derivatives
3 Month Kuala Lumpur Interbank Offered Rate Futures (FKB3)
3-Year Malaysian Government Securities Futures (FMG3)
5-Year Malaysian Government Securities Futures (FMG5)

11
Forward and Futures Contracts
Forward Contract
A contract between two parties agreeing to carry
out a transaction at a future date but a price
determined today
Steps involved in buying crude palm oil:
1. Setting the price to be paid, exact specification
of quality, quantity and delivery logistics, such as
time, date and place
2. Delivering the crude palm oil from seller to buyer
3. Payment of cash from buyer to seller
How does the forward contract work?


12
Time to settle the contract in the future
expiration date
Example: a rice farmer
How long does it take to harvest the paddy?
Price risk
What is the price risk for the farmer?
What is the price risk for the producer?
Since both are facing the price risk, a forward
contract can help them eliminating the price risk.
How?
A seller short position
A buyer long position
13
Forward and Futures Contracts
Futures Contract
To overcome 3 problems of forward
contracts:
1. Multiple coincidence needs
Match the underlying asset, delivery date or
maturity and specified quantity
2. Unfair forward price
The party who has better negotiating power may
dictate unfair price
3. Counterparty risk
One party may default which create losses to the
other party
14
Forward and Futures Contracts
Futures contract
An exchange-traded form of forward contract
A commitment to buy or sell an underlying asset at a
future date
Contracts are standardized
Except for price - quantity, quality of the underlying
asset, deliver date and location of delivery
Traded electronically
The price is determined based on the interaction
between many buyers and sellers
The counterparty risk is reduced through a clearing
house
Guarantees the performance of the parties in each
transaction

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Forward and Futures Contracts
Hedging, Speculating and
Arbitraging with Futures Contracts
Hedging with Futures
The profitability of most individuals and
corporations is affected by the changing prices
of commodities and financial instruments
Risk of price fluctuations (price risk)
Futures markets provide a means of cancelling
out the exposure to drastic price fluctuations in
the underlying or physical market
The purpose of hedging to preserve the
wealth
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Hedging
1. Taking a future position in anticipation of a
later cash transaction (anticipatory hedging) or
Example: the palm oil producer who intends to
sell his palm oil in two months could lock in the
price by selling the futures contract today
If the future price of the palm oil decreases, .
The basic idea of hedging is to establish an
opposite position in futures so that the gain from
the futures position cancels out the loss from the
underlying or physical market position
17
Hedging, Speculating and
Arbitraging with Futures Contracts
2. Taking a future position opposite to the
current physical position held (hedging the
current market position)
Example: a fund manager with a portfolio of
shares could hedge against a fall in share
prices by selling stock index futures contract
today
When the fund manager locks in the price, if
the future price of the index drops, the
decline or loss in portfolio value is
compensated by the gain from the futures
position

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Hedging, Speculating and
Arbitraging with Futures Contracts
How do we determine when we should
buy (long) or sell (short) a futures
contract?
2 ways:
1. To observe the hedge from the underlying
position
2. To observe from the point of price risk. To
protect from the rising prices, the trader
should buy the futures contract. To protect
against falling prices, the trader should sell
the futures contract.
19
Hedging, Speculating and
Arbitraging with Futures Contracts
Advantages of trading futures contracts:
The minimum margin requirements allow
traders to leverage their investments, that is,
to trade many times more than the original
cost of investment
A futures contract does not have to be held
till it expires or matures. It can be closed out
before the contract expires by making an
opposite transaction
Low transaction costs
20
Hedging, Speculating and
Arbitraging with Futures Contracts
Disadvantages of trading futures
contract:
The futures contracts are standardized
May prevent the hedger from benefiting from
favorable price movements
21
Hedging, Speculating and
Arbitraging with Futures Contracts
Speculating with Futures
Deal with price changes that occur in the
market
Try to make profit. Example: buy futures at a
low price, then sell it at a high price
An important role: provide the depth and
volume of trading that allows hedgers and
others to enter or exit the market easily
Provide liquidity and continuous trading
22
Hedging, Speculating and
Arbitraging with Futures Contracts
Arbitraging with Futures
Arbitrage in the practice of taking advantage
of price differentials across different markets
Simultaneous purchase and sale of the same
instrument in different markets to profit from
the temporary price differences
Example: currency trading
Arbitrageurs also play an important role in
providing liquidity and by ensuring the price
of cash and futures converges at the expiry
date of the contract
23
Hedging, Speculating and
Arbitraging with Futures Contracts
Options derivatives
It is a contract between a buyer (option
buyer) and seller (option seller) in which
the buyer of the option has the right but
not the obligation, to buy or sell a certain
asset at a certain price before a certain
date.
What is the difference between the
right and obligation?
24
Selling an option (writing an option)
versus buying an option (take)
The option seller is obligated to perform
according to the terms of the contract
once the option buyer exercises the
option

25
Options derivatives
Difference between options and futures
Right versus obligation
Risk of loss is carried by the option seller
The option buyer is protected from
unfavorable market movements
Fulfillment of the contract
Futures both parties are obliged to transact
at the same specified time in the future
option only one party is obliged to transact,
when the buyer exercising the option.
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Options derivatives
Advantages of options:
Limited risk (applicable to buyers only)
Option sellers have unlimited risk similar to
future holders
Flexibility
Standard options provide flexibility to trade
freely in the open market
Improves liquidity and allowing prices to be
more accurately priced
27
Options derivatives
Exchange-traded options
Originate and traded on a formal exchange
Most commonly are equity options
Traded using electronic trading systems
Settled through a clearing house (MDCH)
Novation
A process whereby it connects the two contracting parties
Standardized except for the price
Over-the-counter options
Not traded through a formal exchange
Arrange deals through telephone or on face-to-face
meetings
Able to negotiate as to quantity, quality maturity and
delivery
Higher credit risk
28
Options derivatives
Uses of Options
1. Investment in options provides leverage
Purchase of option requires only payment of the
premium which is usually a small percentage of the
price of the underlying asset
What about investment in shares?
2. Options can be used extensively in risk
management
Hedging
The use of call and put options in the situation of rising
and falling prices
3. To enhance portfolio returns
Having some shares may allow an investor to sell
call options to others to earn premium
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4. Options are very flexible financial
instruments
Can be used to create strategies to take
advantage of different situations
5. Options are used to manage
information asymmetry
A situation where both parties to the
transaction do not have equal access to
market information
Attach put options with IPO
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Uses of Options
Examples of options traded on
exchanges
Kuala Lumpur Composite Index Options
(OKLI)
SGX MSCI Singapore (SiMSCI) Options
SGX Nikkei 225 Index Options
SGX Eurodollar Options
KOSPI 200 Option
US Dollar Option
Hang Seng Index Options
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The Key Elements of an Option
Types of Options
Call Option
A call option gives the option buyer the right (but not the
obligation) to buy a specified asset at a specified price
at or before a specified date.
When the option buyer exercises the right, the option
seller is obliged to sell the asset to the option buyer.
Put Option
A put option gives the option buyer the right (but not the
obligation) to sell a specified asset at a specified price
at or before a specified date.
When the option buyer exercises the right, the option
seller is obliged to buy the asset from the option buyer.
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Underlying assets
Shares, an index, a particular futures
contract, currencies, gold etc.
An index represents what?
33
The Key Elements of an Option
Strike price or exercise price
It is an agreed price at which the underlying
asset is transacted if the option is exercised
The buyer will only exercise the option when
circumstances favour it
If the strike price is more favourable than the
prevailing price, such an option is described as in-
the-money
So, when does a call option is described as in-the-
money?
When does a put option is described as in-the-
money?
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The Key Elements of an Option
An option is said to be at-the-money if the
exercise price equals the spot price of the
underlying asset
If this kind option is exercised, zero profit on
exercise and loss on the price paid for the
option (premium)
An option price is said to be out-of-money
is the exercise price is higher than the price
of the call options underlying asset
What about a put option? When does it
considered as out-of-money?
For out-of-money, the option will not be
exercised.
35
The Key Elements of an Option
Expiry date and option style
Expiry date is the maturity date
Two types of option styles
American style option
Can be exercised at any time
European style option
Can be exercised only on the specified expiry
date

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The Key Elements of an Option
Premium
Cost or the price of an option
The price that the option buyer pays to the
option seller
Premiums are quoted as index points to one
decimal place
Example: 1 point for RM100, 0.1 for RM10. If the
premium is 25 points, then the price of the option is
RM2,500.
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The Key Elements of an Option
Premium is quoted based on the sum of
intrinsic value and time value
Intrinsic value is the profit that can be
obtained on an immediate exercise
Intrinsic value equals the amount where
option is in-the-money
The option of at-the-money and out-of-money
has zero intrinsic value

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The Key Elements of an Option
39
Potential Gains or Losses on a Call Option:
Exercise Price = $115, Premium = $4
40
Potential Gains or Losses on a Put
Option: Exercise Price = $110, Premium
= $2
Swaps
Swaps are customized bilateral
transactions in which the parties agree
to exchange cash flows at fixed periodic
intervals, based on the underlying asset.
Over-the-counter instrument
Can be 1 month, 3 months, 6 months etc
Each side of swap is called a leg
Interest rate swaps
41
Swaps
Example:
Let say Fair Ltd borrows RM50 million at a
floating interest rate of KLIBOR plus a credit
spread of 0.5% payable in 5 years. Meanwhile,
Adil Ltd borrows RM50 million at a fixed interest
rate of 9% payable also in 5 years.
Fair Ltd and Adil Ltd may agree to swap their
liabilities whereby Fair will pay Adil a fixed
interest of 9% and Adil will pay Fair a floating
rate of KLIBOR plus 0.5%.
Companies involved in the swap agreements
are known as counterparties.
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Swaps
43
Illustration of an Interest Rate Swap to
Reconfigure Bond Payments
Swaps
44