In-Depth Notes on Derivatives and Market Structure

OVERVIEW OF DERIVATIVES

  • Derivatives are financial instruments that derive their value from an underlying asset (e.g., commodity or financial instrument).

    • Example: Crude palm oil futures derive their price from the market price of palm oil.

TYPES OF DERIVATIVES

  • Futures: Contracts to buy/sell underlying instruments at a specified future date for a price set today.

  • Options: Contracts that provide the holder the right (not obligation) to buy/sell at a set price within a time frame, for a premium.

  • Forwards: Similar to futures but are customizable contracts typically not traded on exchanges.

  • Swaps: Contracts where two parties exchange cash flows or liabilities from different financial instruments.

CONCEPT OF DERIVATIVES

  • Derivatives serve as contracts for future transactions, enabling corporations and investors to manage exposure to market volatility.

  • Their value depends on underlying instruments such as commodity prices, exchange rates, interest rates, and stock prices.

CASH MARKET VS. DERIVATIVES MARKET

  • Cash Market: Immediate delivery and payment for commodities or financial instruments.

  • Derivatives Market: Transactions involving future delivery and payment for underlying assets.

TYPES OF DERIVATIVE MARKETS

1. FUTURES

  • A legal agreement between two parties to buy/sell the underlying asset at a designated future time for a price agreed upon today.

  • Contracts detail specifics such as commodity type, quantity, quality, and delivery time.

2. OPTIONS

  • Provides the holder with a right to buy/sell a quantity of the underlying asset at a predefined price within a specific timeframe, paid for via a premium.

  • Obligations arise for the seller when the buyer exercises their option.

BENEFITS OF DERIVATIVES

  • Risk management for underlying asset positions.

  • Portfolio asset allocation to diversify investments.

  • Income generation through strategic positions in derivatives.

THE EXCHANGE

  • A marketplace where derivatives are created and traded.

  • It acts as a communication hub for buyers and sellers and disseminates important pricing information.

  • Functions as a self-regulatory organization establishing trading rules.

EXCHANGE TRADED VS. OVER THE COUNTER (OTC) DERIVATIVES

Feature

OTC

Exchange-Traded

Market Place

Not Centralized

Centralized

Regulation

Self-regulated

Commission-regulated

Trading

Negotiated contracts

Standardized contracts

Margin Payment

No legal requirement

Legal requirement

Credit Risk

High

Low

Transparency

No

Yes

Performance Guarantee

No

Guaranteed by clearing house

CLEARING HOUSE

  • The Malaysian Derivatives Clearing House (MDCH) manages contracts cleared in MDEX, ensuring financial stability by backing contract performances.

  • Acts as the counterparty for trades, utilizing the principle of novation, where the clearing house substitutes itself in contracts to enhance liquidity.

  • Responsible for settling all transactions and maintaining records, matching trades on the exchange, and managing margin requirements.

INTERMEDIARIES IN BM DERIVATIVES

i. FUTURE BROKERS

  • Act as intermediaries between clients and the exchange, executing trades and managing client accounts.

ii. FUTURE TRADING ADVISORS

  • Provide advisory services to investors regarding futures trading strategies but do not perform trading functions or hold direct exchange memberships.

iii. FUTURE FUND MANAGERS

  • Specialize in managing funds that trade in futures and options markets; employ representatives for trading activities.

USERS OF FUTURES & OPTIONS

i. HEDGERS

  • Utilize derivatives to mitigate risks associated with unexpected price movements, aiming to protect their portfolio value.

ii. SPECULATORS

  • Engage in trading futures contracts to profit from market fluctuations, contributing to liquidity despite their acceptance of risk.

iii. ARBITRAGERS

  • Capture risk-free profits through simultaneous trades in multiple markets by exploiting price discrepancies.