CHAPTER 7

FUTURES DERIVATIVES
1

Learning Objectives
Describe a derivative
Describe the history of derivative
Describe the development of derivative in Malaysia
Explain the difference between forward and futures contract
Explain terms convergence, margins and marking to market
and basis risk
Explain the terms hedging, speculating and arbitraging with
futures
Describe the contract specification of FCPO and FKLI
Know how to hedge, speculate and arbitrage using FCPO
and FKLI
Explain and understand the term single stock futures
2

Chapter Outline
Introduction to Derivatives
Forward and Futures Contracts
The Key Elements of in Futures
Trading
Hedging, Speculating and
Arbitraging with Futures Contract
The Crude Palm Oil (FCPO) and KLCI
(FKLI) futures
Single Stock Futures (SSF)
3

What is a derivative?
The word derivative implies they derive their
value from something.
It originates from mathematics and it is a variable
that derives from another variable.
Derivatives on its own have little value but when it
derives from some other asset, known as the
underlying, hence, it has its value.
The underlying can be share prices, prices of
commodity, indices and interest rates.
For example, a derivative of Air Asia shares will
derive its value from share price of Air Asia
(underlying).
Similarly, a derivative contract on Crude Palm Oil
depends on the price of palm oil and the derivative
of Kuala Lumpur Composite Index (KLCI) will
depend on the movement of the KLCI.
4

Why do derivative markets

exist?
Largely to facilitate hedging.
The derivative markets are largely
insurance markets.
Firms, like individuals are risk averse
and would like to protect themselves
against three main types of risk that
businesses face: PRICE RISK,
CURRENCY RISK and INTEREST RATE
RISK.
5

SPOT MARKET vs
FORWARD/FUTURES
MARKETS
In the spot (cash) market, buyers and sellers
agree on Price (P) and Quantity (Q) for
immediate delivery (or within a few days).
Example: Proton buys 1 million Japanese Yen
in the spot market for currency, or it buys
100 tons of steel in the cash market for
steel. MAS buys 500,000 gallons of gasoline
in the spot market.

FORWARD CONTRACT
Private contracts between two
parties (buyer and seller) for delivery
sometime in the future (one month,
one year).
Not marketable securities and there
is no secondary market.
E.g. like the difference between a
bank loan (not marketable) and a
bond (marketable).
7

Mechanics of Forward Contracts: An illustration

Assume there are 2 parties a cocoa

farmer who has planted cocoa on his
farm and is expecting to harvest the
cocoa in 6 months and a confectioner
who produces chocolate using cocoa
powder.
Assume further that the confectioner
has in his inventory, sufficient cocoa
to last him for the next 6 months, but
would have to replenish his stock at
the end of the sixth month. Clearly,
both parties here are exposed to risk,

 The cocoa farmer faces the risk that the

spot price of cocoa could fall between now
and 6 months from now, when he
completes his harvest. Such a fall will
obviously reduce his revenue and profits.
Infact, if the fall in spot price is sharp
enough, he could even face outright
losses.
The confectioner faces similar risk but in
the opposite direction. The spot price of
coca could increase between now and 6
months from now when he needs to
replenish his inventory. Any increase in
prices will increase his costs and reduce
his profits.

 Since both parties face price-risk and

neither party can tell which way prices
would go, it would be in their interest to
go into an arrangement that could protect
them from this price-risk. Such an
arrangement would be the forward
contract. Under the forward contract, the
farmer would agree to deliver and the
confectioner to take delivery of cocoa of
an agreed quantity on a mutually
agreeable date and at a price determined
now i.e. at the time of initiation of
contract.

Step 1 (at initiation of contract; day = 0)

Farmer
(Short position)

negotiate
Agree on :
Price, quantity, quality,
maturity delivery location
etc.

Confection (Long
Position)

Step 2 (on maturity date; day = 180)

Farmer
(Short position)

Cocoa
Money

Confection (Long
Position)

The
The long
long position
position agrees
agrees to
to take
take delivery
delivery (buy)
(buy) of
of the
the underlying
underlying asset
asset while
while the
the
short
short position
position agrees
agrees to
to make
make delivery
delivery (sell).
(sell).

FORWARD CONTRACTS
EXAMPLE 1
Giant Supermarket enters into a forward
contract in May to purchase rice at harvest
time in October, at a guaranteed price, from
various rice farmers for their entire crop.
Advantage: buyer (company) and seller
(farmer) gave a guaranteed price. They are
now protected from price swings in rice.
They have eliminated price risk completely by
hedging their position, locking in a price with
a forward contract.

12

FORWARD CONTRACTS
EXAMPLE 2
Toyota Motors enters into a contract
for British pounds with Bank One, to
either buy pounds or sell pounds, in
six months at a guaranteed
exchange rate. By locking in, Toyota
Motors has hedged currency risk.

13

Advantages/Disadvantages
of Forward Contract
Advantage: They are very flexible and can be
customized to the needs of the parties.

Disadvantages:
There is no liquid market for forward contracts,
no secondary market.
Problem in price fixing. The party who has better
negotiating power may dictate an unfair price.
High default risk. One party may default (not
fulfilling the future obligation agreed upon
earlier), resulting in losses for the other party.
This risk is known as counterparty risk.
Requires actual delivery to complete the
contract..

14

FUTURES CONTRACTS
Are the same in principle as a
forward contract, where two parties
(buyer and seller) agree to
trade/exchange something (rice,
corn, oil, T-bills, Yen) in the future
(one week, one month, one year),
but they agree on P and Q now, for
future delivery, using a futures
contract from a futures exchange
an organized market for trading

15

What is a futures contract?

exchange-traded form of forward contract
Basically to overcome 3 problems of forward
contract
(1) multiple coincidence needs,
(2) unfair forward price and
(3) counterparty risk.

Because they are exchange-traded, the

contracts are standardised.
Except for price the standardised contract
would have specified the quantity (or the
contract size), quality (or the grade) of the
underlying asset, delivery date (or the expiry
date) and location of delivery.
16

Multiple Coincidence of Needs

At least three things must match before the two
parties in a forward contract can even begin to
negotiate prices.
(i) asset match
(ii) maturity match
(iii) quantity match
There could be others such as delivery location
etc. The result is that there could be substantial
search costs involved. One party will have to
search out the other thereby incurring costs in
terms of time, advertisement etc.

Potential for Price Squeeze/Unfair Price

In a forward contract, the forward price is
arrived at through negotiation.
The problem with negotiation is that,
bargaining position matters. If one party is in
a weak bargaining position, he could be
squeezed by the other.
However, if there is only one confectioner
(potential buyer of cocoa) in the district but
several cocoa farmers, the long position has
the bargaining power and could dictate on
price.

 In such a situation, even if the cocoa

farmer feels the price offered may
not be fair, he may have little choice
but accept the price. This would be
particularly so, if the product is
perishable and could spoil shortly
after harvest. The short position
does not have much of an option to
wait and see if he could fetch a
better price post harvest.

Counterparty / Default
Risk

Counterparty risk or default risk, refers to the

possibility that one of the parties to the
transaction could default. Such default could
happen not so much because the party is
dishonest but rather due to the incentive to
default given changes in the spot price.
However, if spot prices subsequently begin to
fall, the long position (confectioner) begins to
hurt since he has agreed to forward price
based on the higher previous spot price.

 The opposite is true if spot prices begin to rise

after the forward contract is negotiated. Now,
the short position, the farmer, begins to hurt
since he would feel that his cocoa could now be
sold at higher prices. He would regret having
locked himself into the low forward price.
We assume that the two parties had agreed on
a forward price of RM100 per ton. We examine
what will happen if say, the spot price on
maturity day is at RM70 per ton or RM120 per
ton.

Advantages of futures contracts

over forward contracts
Liquid market, lots of buyers and sellers at
organized exchanges all over the world.
Active secondary market. Contract may trade hands
many times before expiration.
Minimal risk. The futures exchange requires an
initial margin to open a position and they enforce
daily settlement of all gains and losses to avoid
default. There is maximum price movement, called
daily limit, to minimize large losses. For example,
daily price limit for palm oil futures is 10% above or
below the settlement price of the preceding
business day, trading stops for the day.
22

Advantages of futures contracts

over forward contracts
The counterparty risk is reduced through a clearing
house which take responsibility for ensuring the
contract is brought through without any parties
defaulting in the transaction.
Cash settlement for most futures contracts, instead
of settlement in the actual commodity.
You can close your account anytime by taking an
offsetting position. If your original position is to buy
(go long) a futures contract, you can subsequently
sell (go short) to close out your position, and vice
versa. You can cash out without having to make or
receive delivery.
23

Disadvantages of futures
contracts over forward contracts
Less flexible since futures contracts are for
fixed, standard amounts, e.g. palm oil futures
contracts are for 25 metric tons per contract.
Expiration dates are fixed: E.g. Jan, March,
September and December. (only few delivery
per year.
The location for delivery are fixed (Port
Kelang, Penang/Butterworth and Pasir Gudang
(Johor)

24

Examples of futures contracts traded in

Bursa Malaysia Derivatives Bhd
Stock Index Futures
KLCI (FKLI) Futures

Single Stock Futures (SSFs)

Interest Rate Futures
3 Month Kuala Lumpur Interbank Offered Rate interest rate
(FKB3)

Bond Futures
3-Year Malaysian Government Securities (FMG3) Futures
5-Year Malaysian Government Securities (FMG5) Futures
10-Year Malaysian Government Securities (FMGA) Futures

Agriculture Futures
Crude Palm Oil (FCPO) Futures
Crude Palm Kernel Oil (FPKO) Futures
USD Crude Palm Oil (FUPO) Futures
25

The Key Elements of Futures Trading

Convergence of Futures and Cash
Prices
Basis and Basis Risk
Margins and Marking to Market
Types of orders
The Clearing House

26

Price Convergence
The futures price of a contract and the cash
price (spot price of the underlying) of the
same commodity tend to converge, i.e. they
will come together as the delivery month of
the futures contract approaches. On maturity
date, the futures price must equal spot price.
When futures price > spot price = contango.
When futures price < spot price =
backwardation.
Determined by market forces (ss and dd)

27

The Convergence
Property

The convergence property states that the

price of a futures contract on the day of
its maturity must equal the spot price of
the underlying on that day.
The logic for this is that, on its maturity
day, a futures contract is essentially a
spot asset.
The Spot Price and the Future Price must
be equal otherwise there would be a
riskless arbitrage opportunity. One could
even argue that the existence of such
arbitrage opportunity would ensure

Spot-Futures Convergence at
Maturity

Spot/Futures Price

Futures
Spot

Maturity day

Basis and Basis Risk

Basis is the difference between cash price
(or spot price), S and Futures price, F.
It reduces to zero at it approaches
maturity of the futures contract.
In a perfect hedge, the gains or losses in
the futures contract exactly offset the
losses or gains of the underlying asset
being hedged.
If do not perfectly cancel each other out, it
is called basis risk. Due to mismatches of
quality (grade), location, maturity, qty.
30

Basis and Basis Risk

The difference or spread between the
futures and spot prices is often known as
the basis. The basis should equal the net
carrying cost.
The basis narrows over time to reach zero
at maturity. Prior to maturity however, the
basis would be positive or occasionally
negative.

Basis Ft ,T S o

 Basis risk can be thought of as

tracking error. Basis risk would be
present whenever there is any of
these three mismatches:
(i) Asset mismatch
(ii) Maturity mismatch and
(iii) Quantity (or contract size)
mismatch.

Margins and Marking to

Market

Example:

Consider an investor, contacts his broker on

Tuesday, 2nd of June to buy two December
crude palm oil futures contracts at Bursa
Malaysia Derivative Berhad. One futures
contract equivalent to 25 metric tons. Current
market price is RM2,000 per ton.
Therefore, the investor is contracted to buy 50
metric tons at this price. The total value of this
transaction:
= 2 contracts x 25 metric tons x RM2,000
= RM100,000
33

Margins and Marking to

Market
The broker requires
the investor to deposit
some money in a margin account (initial
margin). Assume that the initial deposit is
RM10,000 per contract = Initial Margin =
RM20,000.
At the end of each day, the margin account is
adjusted to reflect the investors gain or loss.
This is the additional margin payments that
would have to be paid and is called the
variation / maintenance margin.
This practice is referred to as marking to
market or (marked to market).
34

Margins and Marking to Market

Assume that at the end of the day, the palm oil futures price
closes at RM1,850 per ton. This implies that the investor has
made a loss = 2 contract x 25 metric tons x RM150 =
RM7,500
If the price for the following day closes at RM2,300 per ton,
the balance of the margin account will increase by:
2 x 25 x RM450 = RM22,500
Hence for the last two days, the margin balance has become
RM35 000 = (RM20,000 RM7,500 + RM22,500)
The investor is entitled to withdraw any balance in the
margin a/c in excess of the initial margin (IM) = RM15 000
To ensure that margin a/c does not become negative, a
maintenance margin is set (usually lower than IM).
If the balance falls < maintenance margin, the investor will
receive a margin call. He is expected to top up the difference
back to the initial margin the following day.
35

DAY

Price

Variation gain/loss

Balance

2000

Pay margin 20 000

20 000

1850

(7500)

12 500

2300

450 x 2 x 25 = 22500

35 000

36

The Clearing House

Acts as intermediary in futures
transactions.
Guarantees the performance of the
parties in each transaction.
To ensure none of the parties are
hurt by the defaulting party.

38

Crude Palm Oil (FCPO) Futures and

KLCI (FKLI) Futures
The Underlying Instrument of FCPO
and FKLI
The Contract Specification FCPO
refer to Table 7.1 page 192
The Contract Specification FKLI
refer to Table 7.3 page 196

39

Trading Practicalities
Long bought futures contract
Contract to receive delivery/contract to buy
underlying asset
eg: Long 2 August 2011 FCPO at RM1000/tonne
[ Engage in contact to receive delivery of 50
tonnes of CPO in August 2011 at RM1000/tonne]

Short sell futures contract

Contract to make delivery/contract to sell
underlying asset
Short 2 Aug 2011 at RM1000/t
[ Engage in contract to deliver 50 tonnes of CPO
in Aug 2011 at RM1000/t]
40

EXERCISE
Long 3 Dec 2012 FCPO @RM1,200
TODAY:
A contract to buy 75 tonnes of CPO in Dec
2012 at RM1,200

At maturityDec 2012
BUY 75 tonnes of CPO and pay RM1,200
Physical settlement
OR
SELL 3 Dec 2012 FCPO at price of Dec 2012
FCPO traded in Dec 2012. cash settlement
41

EXERCISE
Long August FKLI @ 1120
Contract to buy KLCI in August @
1120
SETTLEMENT
CASH Settlement
Sell Aug FKLI @ price of AUG FKLI
traded in Aug.

42

Forwards, Futures; Zero sum Game

In a world of limited/finite resources, most
financial transactions, including all
derivatives transactions are zero-sum
games; that is one partys gain is at
another partys expense.
if spot prices rise
Profit to Long = Spot price at Maturity
Original Futures Price
(the short positions implied loss equals
this amount)
if spot prices fall
Profit to Short = Original Futures Price
Spot price at Maturity.

Types of Futures Markets Participants

Hedgers
Speculators
Arbitrageurs

44

Hedgers
Futures traders who have a personal
or business interest in the future
commodity prices, exchange rate or
interest rate.
E.g. importers/exporters,
corporations buying and selling in
the future, farmers, portfolio
managers, firms expecting to borrow
money in the future, firms/investors
expecting to invest money in the

45

Hedgers - Examples
Farmers (sellers) and producers are worried
about the price of their product going down in
the future. They can use futures contract to
lock in price now for future output of oil, corn,
wheat, sugar, steel, gold etc by going SHORT
on contracts for their product.
Exporters (importers) receiving foreign
currency (paying in foreign currency) can
hedge risk by going short (long) on currency
futures.

46

 Given the KLCI is 1050 and the value of a

portfolio is RM3 million. If the portfolio manager
wishes to hedge 80% against a price decrease,
how many contracts will the portfolio manager
have to trade? Does the trader buy or sell?
Suppose in February, a palm oil producer
anticipates that he will have 180 metric tonnes
of crude palm oil ready for sale in four months
time. He would like to fix the price for his
produce. The current market price (February) of
the palm oil is about RM2,250 per metric tonne
while the June crude palm oil futures (FCPO)is
currently trading at RM2,265.
47

Types of Hedging
Hedging is taking a (1) future position in
anticipation of a later cash transaction or (2) taking
a future position opposite to the current physical
position held.
The former type is known as anticipatory hedging
and the latter type is known as hedging the current
market position.
An example of anticipatory hedging is the palm oil
producer who intends to sell his palm oil in 2
months could lock in the price by selling the futures
contract today.
An example of hedging current market position is
the fund manager with a portfolio of shares could
hedge against a fall in share prices by selling
(taking a futures position opposite to the current
position of holding a portfolio of shares) stock index
futures contracts today.
48

Strategy
Number of contracts
Contract Month
Action

49

Types of Hedging
anticipatory hedging
- Refer to Table 7.5 page 199

hedging the current market position

50

An Anticipatory Hedge
Often, producers may not have an immediate position in
an underlying asset but a potential position. That is, they
anticipate having a position in the underlying asset at a
future point.
Assume that the farmer is expecting to produce 120 tons
of cocoa in 6 months and wishes to hedge his price-risk.
Suppose further that cocoa futures are maturing in 6
months from now and have a standard size of 10 tons per
contract. The current quoted price for 6 month cocoa is
say RM100 per ton or RM1,000 per contract. For
simplicity, assume that the confectioner also requires 120
tons in six months
Notice that the cocoa farmer in our example did not have
an immediate exposure. He is expecting to harvest cocoa
in 6 months. Yet, he hedges the position today. This is
what is known as anticipatory hedge.

 Each party could do their hedging through the

futures market as follows. The farmer would call
his futures broker and short (sell) 12 cocoa futures
for 6 month delivery while the confectioner would
instruct his broker to long 12 such contracts.
At this point both parties would be fully hedged
since in 6 months the confectioner knows he will
have to pay exactly (RM1,000 x 12) = RM12,000
for the 120 tons of cocoa he needs while the
farmer is assured of RM12,000 as payment for his
cocoa.

 Notice that neither party needs to know

who the counter party is. Yet, each party
is assured of delivery/payment because
the exchange (through its clearing
house) becomes the counter party to
both the farmer and confectioner.
On registration of the trade, the
clearinghouse guarantees the
transaction. Assuming both parties hold
their position to maturity, the cocoa
futures contract will be settled on its
maturity day (day 180) as follows.

Settlement of A Futures Contract

Cocoa
Warehouse
receipt

Exchange
Designated
Warehouse

Cocoa
Warehouse
receipt

(1)
(2)
(5)

Cocoa
Farmer
(short)

(3) w. receipt

Payment
(4)

Exchange
(Clearinghouse)

(3) w. receipt

(6
)

Confectioner
(Long)

Payment
(4)

Numbers within brackets show the sequence of events

Example
Suppose in Feb, a crude palm oil producer anticipates
that he will have 200 metric tons of crude palm oil
ready for sale in two months time. He would like to
lock in the price of his crude palm oil. The current mkt
price (Feb) is RM1,250 per metric ton. April crude
palm oil futures is currently trading at RM1,265.
His exposure to risk = price may fall between now
(Feb) and the time of sale (April) = risk of price
decline.
Action: Sell futures (short position) of a specific
number of contracts at a certain point in future
= 200 tons/25 = 8 contracts
Contract Month: April
55

 Assume in April the price of crude palm oil in

the spot market has dropped to RM1,245/ton.
So has the April futures (price convergence).
The producer sells the CPO in the spot market
for RM1,245 and also closes out the futures
position by buying (long position) 8 futures
contracts at RM1,245.

56

Summary of the
Positionpositions:
Today
Position at Maturity

Gains/Los
s

Cash Mkt

Mkt price = RM1,250

Mkt price = RM1,245

Action: sells 200 tons
at RM1,245.
Total sales = 200 x
RM1,245 = RM249,000 RM249,000

Futures
Mkt

Mkt price = RM1,265

Action: short futures
= 8 contracts at
RM1,265
Total value of futures
= 8 x 25 x RM1,265
= RM253,000

Close its position by

buying 8 futures
contract @RM1,245.
Action: Long Futures
= 8 x 25 x RM1,245
= RM249,000

RM4,000

Total revenue

RM253,00
0

Effective price per

metric ton

RM1,265
RM253,000
200
tons 57

Example
Suppose in May, a crude palm oil refiner receives an order
for a 800 met tons of refined PO to be delivered in Sept.
He would like to lock in the price of his crude palm oil. The
CPO futures for delivery in Sept is trading at RM1,270.
Current spot price = RM1,265 (lower than futures price).
However he does not have the available cash to buy now.
His exposure to risk = price may increase in the future.
Action: Buy futures (long position) of a specific number of
contracts at a certain point in future
= 800 tons/25 = 32 CPO Sept futures contracts at
RM1,270.
(he needs to pay only the initial margin)
This gives confidence to the oil refiner to quote the price to
his customers using known PO cost.

58

Example
In Sept, he purchases the 800 met tons of CPO
in the spot market at RM1,278
He closes out the futures position by selling
(short position) 32 futures contracts at the
current mkt price of RM1,278.

59

Summary of the positions:

Position Today
Cash Mkt

Position at Maturity

Mkt price = RM1,265

Mkt price = RM1,278
The refiner needs 800 met Action: buys 800 tons
tons of CPO in Sept.
at RM1,278.
Total costs:
= 800 x RM1,278
= RM1,022,400

Futures Mkt Mkt price = RM1,270

Action: buy futures
= 32 contracts at RM1,270
Total value of futures
= 32 x 25 x RM1,270
= (RM1,016,000)

Gains/Loss

(RM1,022,400)

Close its position by

selling 32 futures
contract @RM1,278.
Action: sell Futures
= 32 x 25 x RM1,278
= RM1,022,400

RM6,400 (Pft)

Net costs

(RM1,016,000)

Effective price per

metric ton

RM1,270
(RM1,016,000)
800 tons

60

SPECULATORS
Have no personal or business interest in the
commodity or currency. They are trading futures
contracts as a purely speculative investment or
gamble.
For example, an investor could take a position on
a palm oil futures contract for March 2009 @
RM1,250 per metric ton, and they are not in the
palm oil business, they have no interest in
actually receiving or delivering palm oil at
expiration. They are just taking a position on the
price of palm oil in the future.
Speculators can participate in futures trading
because actual delivery is not required.
61

SPECULATORS EXAMPLE
If a speculator thinks that the cash price of
palm oil will go above RM1,250 sometime
between now and June 2009, they take a
LONG POSITION, and buy palm oil futures
contracts. They are speculating that the
P > RM1,250, and will make money if that
happens. They buy @RM1,250 and hope
to sell at P > RM1,250. Speculator is
gambling (betting) that the price of palm
oil will be > RM1,250.
62

SPECULATORS EXAMPLE
If the speculator thinks that the cash
price of palm oil will go below
RM1,250/metric ton, he will take a
SHORT POSITION, and sell palm oil
futures. He will make money if
P < RM1,250, they are betting that
the price of palm oil will fall.

63

Speculating with Futures Contract

Speculators deal with price changes that
occurred in the market.
They are motivated by the strong desire to
make profit on the transaction.
They will buy the futures at low price and
sell at high price.
The speculative traders in the futures market
help to fulfil a very important role. They
provide the depth and volume of trading that
allow hedgers and others to enter or exit the
market easily.

64

Three types of speculators

The scalpers look out for minimum price

fluctuations on heavy (large) volumes taking
small profits at a time. They aim to make small
profits on large volumes of transaction.
The day traders do intraday trading and on
small volumes of trade. The typical day trader
would take long or short positions of a few
contracts and would close-out their positions
later in the day when the prices have moved.
The position traders look for long-term price
trends and may hold over weeks, or months
before getting out.

65

Using CPO Futures to Speculate

Outright position speculative strategy
Takes a view of the change of the futures
prices and speculate on it
refer to section 7.5.4.1 page 202

Spread trading speculative strategy

Based on expectations of changes in
relationship between several futures
contract
refer to section 7.5.4.2 page 203
66

EXERCISE:
A trader takes a view that March FKLI
which are currently trading at 1158.6 are
about to enter a downtrend.
Should the trader go long or short futures.
Assuming that the trader maintains his
position until expiry and the cash settlement
price is 1125.4, what will be the profit/loss.

Profit = (1158.6-1125.5) x RM50 =

RM1660
67

EXERCISE
A palm oil producer firmly believes
that the price of crude palm oil is
about to enter an uptrend. It is now
October and the trader buys 6
November CPO futures at RM1,370.
The margin for CPO is RM8,000 per
contract.
Calculate profit and loss on the
transaction if the trader decides to
close the contracts on day 5. The
price of FCPO on day 1,2,3,4, and 5
68

EXERCISE
Suppose in March, the April FCPO contract is
trading at RM1,225 while the May contract is
trading at RM1,100. Assume that between
March and April, FCPO fell quite sharply. The
trader anticipates that the spread to be
narrowed.
Outline the strategy that the trader should take.
Assume that April FCPO is traded at RM1140
upon maturity, calculate the profit/loss if the
spread between April FCPO and May FCPO is 70
points.
69

 Spread Narrow
Price

1225
Spread 70 points
1100
Time

Buy May FCPO and Sell April FCPO

Profit/Loss = (1210-1100) + (12251140)
= 195 X 25
= 4875
70

Arbitraging with Futures Contract

Arbitrage is simultaneous purchase and sale of the same
instrument in different markets to profit from the
temporary price differences or inconsistencies.
How did arbitrage ensure price convergence?
An arbitrage is a trade that involves buying in the
physical market and selling at the futures market at a
higher price.
A trader who initiate the arbitrage if observes the prices
are traded above the fair values will act on by selling
the futures where the prices are high and pushes the
price back to the fair value as determined in the physical
market.
Provide liquidity and ensuring the price of cash and
futures converges at the expiry date of the contract.
71

Fair value of futures price using cost of

carry model

F S (1 r c y )

where
F = futures price for a contract with maturity from
time t to T at maturity
S = cash or spot price of the underlying asset
r = annualised risk-free interest rate (a proxy for
opportunity cost)
c = annualised cost of storage (%) (inclusive of
shipping, handling, shrinkage, spoilage or
damaged,
etc)
y = convenience yield on the cash commodity
t = time to futures expiry expressed on yearly
basis
72

Fair value of futures price using cost of

carry model

Example:
Spot price = RM1,275
Storage = RM5 per month
Risk-free rate = 4%
1-month Futures contract = RM1000

Theoretical Fair price:

F = RM1,275 (1 + 0.04 + 5x12/1,275)
= RM1,283.78

30/365

73

 Is it possible to make a gain if the

actual futures price is lower than the
fair price? If so, describe the strategy
a trader could use in this situation.
If the 1-month FCPO is traded at
RM1500. Calculate the PL if any.

74

Using CPO Futures to Arbitrage

Find the fair value of the futures price
If the actual futures price > fair value,
overpriced position sell futures and buy the
spot or physical market
If the actual futures price < fair value,
underpriced position buy futures and sell the
spot or physical market
An illustration of how to calculate fair value of
the CPO futures page 204
Table 7.7 shows the outcome of arbitraging.
75

Example
In March, the spot price for CPO is
RM975. If the cost of storage is RM 5 per
month and the risk free rate is 5%, what
is the upper limit for the April futures
price assuming the contract expires in
one month?
FV = 975([1+(0.05 )] + [(5*12/975)])30/365
= 983.51 FV April FCPO
[ April FCPO should trade above this limit]
76

 Assume that April FCPO are currently trading

at RM1000 per tonne.
Arbitrage opportunity exist coz April futures
are not correctly priced, OVERVALUE
Strategy;
Today;
Sell April FCPO at RM1000/t coz overvalue
Buy CPO at RM975/t; store at RM5 per month.
Upon maturity, deliver CPO to buyer and
receive RM1000/t.
Profit: 1000 975 5 = RM20/t

77

EXERCISE
Today is early October. You believe
that quotations of FKLI are
mismatched. Currently the spot
index is quoting at 990 while
November FKLI at 1060. You expect
average dividend yield of 3.5% and
risk free rate of 6.5% per annum,
show your arbitrage activity and
profit if both indices converged at
1020 in the last day of November for
78

F S (1 r c y )

F = 990 (1+ 6.5% + 0 3.5%)61/365

F = 994.90
Overpriced:
Today: Sell 94 Nov FKLI @ 1060
Buy RM5 million shares @ 990. Hold temporarily

Later: Buy 94 Nov FKLI @ 1020

Sell shares that worth
( 5M + ( 1020-990/990)5M= 5151515.152
79

Arbitrage Profit
Description

Profit

Futures Profit (1060-1020) x 94 x

50
Cash
[(1020-990)/990 ] x
Portfolio
5M
profit
Interest exp 6.5% x 5 M x 61/365

188000

Div yield

3.5% x 5M x 61/365

29247

TOTAL

314447

151515

(54315)

80

EXERCISE
Your bank is willing to finance the
purchase of physical shares for 3M
through arbitrage activity. You
observe that the spot index is
currently trading at 965 while July
FKLI at 1088. Assuming your cost of
funds is 7.5% per annum and
dividend yield of 4.5% for 90 days
holding. Show your arbitrage profit
(if any) if July FKLI converge with
81

 F = 972.05
No of Contract = 3M /(1088 x 50) = 55 contracts
Today
Sell 55 July @ 1088
Buy RM 3M shares on a borrowed funds CI 965

Later
Buy 55 July @ 1050
Sell Shares @ [3M+(1050-965/965)x3M]= 3,264,248.70
Receive dividend for 90 days
Pay interest for 90 days

Profit
(3,264,248.70 -3M) + (4.5% x 3M)90/365
(7.5%x3M)90/365 + (1088 1050)55 x 50
=
82

Example;

Suppose you observe the following quotations today.

3-month FKLI price
= 1,210
Index value
= 1,200 pts
rf rate
= 4%
Dividend Yield
= 2%
Time to maturity of SIF = 90 days

To see if arbitrage is possible we first check for

mispricing. The correct value of the 3-month FKLI
should be;
Ft = 1,200 (1+.04-.02)0.25
= 1,200 (1.02)0.25
= 1,205.96 points

Given the above information, the futures is clearly overpriced

relative to spot. The futures price should be 1,205.96 points,
yet it is quoted at 1,210 points. Overpriced by approximately 4
points.
Since there is mispricing, arbitrage is possible. By using the
following arbitrage strategy a riskless profit can be made.
(Note that no cash outlay is needed today
we will look at 2 market scenarios. (Note: current stock index value is 1,200 pts)

Index Rises to 1225 at maturity

Index Falls to 1175 at maturity

Scenario 1: Index Rises to 1225

Cash & Carry Arbitrage

Action

FKLI

Position
Today

Position At
Maturity

Profit/Loss

60,500
(1210 x 50)

(61,250)

(750)

(60,000)

61,250

1,250

(I)

Short
1
Contract

(I)

Long Spot

(I)

Borrow RM60,000
@ 4% for 90 days.

60,000

(60,591.20)

(591.20)

(I)

Receive divs. and

invest it @ 4% for 90
days.

303

303

Net =

211.80

Scenario 2: Index Falls to 1175

Cash & Carry Arbitrage

Action

FKLI

Position
Today

Position At
Maturity

Profit/Loss

60,500

(58,750)

1,750

(60,000)

58,750

(1,250)

(I)

Short
1
Contract

(I)

Long Spot

(I)

Borrow RM60,000
@ 4% for 90 days.

60,000

(60,591.20)

(591.20)

(I)

Receive divs. and

invest it @ 4% for
90 days.

303

303

Net =

211.80

Reverse Cash and Carry Arbitrage

Suppose in the above example, the Futures price today is quoted
as;
3-month SIF price = 1201
Now, the SIF is underpriced relative to spot. In order to
arbitrage we need to do the reverse of the earlier strategy
The following reverse Cash and Carry arbitrage would be
appropriate here

Index Rises to 1225

Action

Position
Today

Position At
Maturity

Profit/Loss

(I)

Long 1 SIF Contract

60,050

61,250

1,200

(I)

Short Spot

60,000

(61,250)

(1,250)

(I)

Lend RM60,000 @
4% for 90 days.

(60,000)

60,591.20

591.20

(I)

Borrow RM300 @
4% to replace divs.
on borrowed shares
(shorted).

(303)

(303)

Net =

238.20

Index Falls to 1175

Action

Position
Today

Position At
Maturity

Profit/Loss

(I)

Long 1 SIF Contract

60,050

58,750

(1,300)

(I)

Short Spot

60,000

(58,750)

1,250

(I)

Lend RM60,000 @
4% for 90 days.

(60,000)

60,591.20

591.20

(I)

Borrow RM300 @
4% to replace divs.
on borrowed shares
(shorted).

(303)

(303)

Net =

238.20

Single Stock Futures (SSFs)

SSFs are based on individual stocks
listed in Bursa Malaysia and
therefore, it tracks the movement of
the individual underlying stock.
As of now, there are 9 SSF contracts.
The contract specification refer to
Table 7.10 page 213.

90