Chapter 5 (Derivatives Market)

Derivatives: Core Concepts

• A derivative is a financial security whose payoff is linked to ("derived from") the value of another security (the underlying).
• Standard agreement between two parties to exchange an asset or cash flow at a pre-determined price on a future date.
• When the value of the underlying changes, the value of the derivative also changes.
• Primary functions: hedging, speculation, arbitrage, price discovery.

Classification of Derivatives in Malaysia

• Exchange-Traded Derivatives (ETD)
  • Traded on formal exchanges (e.g., Bursa Malaysia Derivatives, BMD).
  • Contracts are standardised (size, maturity, settlement, etc.).
  • Exchange & clearinghouse = counterparty ➔ lower credit risk.
  • Major ETD products: options & futures on financial instruments, equities, commodities.
• Over-the-Counter Derivatives (OTC)
  • Privately negotiated, bespoke terms, higher flexibility.
  • Higher counter-party/credit risk; no central clearing.

Common Underlying Assets

• Financial derivatives: government bonds (3-, 5-, 10-year), money-market rates, equity indices.
• Commodity derivatives: agricultural goods (e.g., crude palm oil) & precious metals (e.g., gold).

Futures Contracts

Definition & Essence

• Agreement to exchange a set quantity of an asset in the future at a price settled daily (marked-to-market).
• Standardised, exchange-traded ➔ transparency & liquidity.
• Clearinghouse interposes itself, ensuring obligations are met; default risk reduced via margins.

Key Features (Standard Contract Specification)

• Contract size, tick size, contract months, last trading day, delivery terms (physical or cash), final settlement price, expiry date.
• Obligatory for both buyer (long) & seller (short).
• Leverage: only margin (not full contract value) is posted.

Mark-to-Market (MTM)

• Price of futures re-priced daily to reflect underlying price.
• Daily cash settlement transfers gain/loss $\text{Gain/Loss}<em>t = (P</em>t - P_{t-1}) \times Q$
• Ensures each side maintains sufficient funds for eventual payoff.

Delivery & Default Handling

• Contract may require physical delivery or cash settlement at expiry.
• If a party defaults, exchange/clearinghouse assumes the position.

Bursa Malaysia Derivatives (BMD) — Products

• Interest-rate futures: $\text{FBK3}$
• Stock-index futures: $\text{FKLI},\;\text{FM70}$
• Bond futures: $\text{FMG5},\;\text{GMG3},\;\text{FMGA}$
• Commodity futures: $\text{FCPO},\;\text{FPOL},\;\text{FUPO},\;\text{FPKO},\;\text{FGLD},\;\text{FTIN}$
• Trading platform: Bursa Trade Derivatives (BTD) – fully electronic, replacing open-outcry.

Trading Mechanics

• Open-outcry vs. Electronic
  • Open-outcry: traders shout bids/offers in a pit.
  • Electronic: global 24-hour access, faster execution, better transparency.
• Order types
  • Market order: execute at best price.
  • Limit order: execute at specified price.
• Positions
  • Long = buy futures (profit if price ↑).
  • Short = sell futures (profit if price ↓).

Clearinghouse Functions (BMDC)

• Breaks each trade into buy & sell, becoming counterparty to both.
• Guarantees performance via margin deposits.

Futures Quote Breakdown (FCPO example)

• Contract name (e.g., Crude Palm Oil Futures).
• Delivery/expiry month: last day to settle or roll.
• Opening price, bid (highest price willing to pay), ask (lowest price willing to accept), last price.
• High/low of session, volume, open interest, settlement price.

Closing (Liquidating) a Position

• Offset the original trade prior to expiry (most common).
• Hold to expiry and take/make delivery.

Trader Categories

• Speculators: long for price rise, short for price fall.
• Hedgers: lock-in prices to manage risk.
• Arbitrageurs: exploit price differentials between spot & futures.

Profit & Loss Illustrations

• FCPO (Crude Palm Oil)
  • Contract size: 25 MT.
  • $\text{Tick} = 1\text{ RM} \Rightarrow \text{Value} = 25\text{ RM}$
  • Long at RM3,500 → price ↑ to RM3,600:
    $\text{Profit} = (3{,}600-3{,}500)\times25 = \text{RM}2{,}500$
  • Price ↓ to RM3,400 → Loss = RM2,500.
• FKLI (KLCI Index)
  • Contract size: RM50 per index point.
  • Tick: 0.5 point = RM25.
  • Long at 1,500 → index 1,520 ⇒ $20\times50 = \text{RM}1{,}000$ gain.
  • Short at 1,500 → index 1,480 ⇒ same RM1,000 gain.

Margin System

• Initial Margin: up-front deposit (e.g., FKLI ≈ RM4,200–RM5,000; FCPO ≈ RM4,000–RM5,000).
• Maintenance Margin: minimum balance; falling below triggers margin call.
• Margin call example (FCPO):
  • Buy at RM3,000; price ↓ to RM2,900 (loss RM2,500).
  • Initial margin RM5,000; maintenance RM4,000.
  • New balance = RM2,500 (< maintenance) ⇒ margin call for RM2,500 to restore to initial.

Options Contracts

Fundamental Definition

• Gives holder the right (not obligation) to buy (call) or sell (put) an underlying asset at a fixed price (strike $X$) on/ before expiry.
• Buyer pays premium; seller (writer) receives premium.
• Two key differences vs. futures:
  1. Premium upfront & limited buyer loss to premium.
  2. Buyer can choose not to exercise; futures are obligations.

Call vs. Put / Rights & Obligations

• Call buyer: right to buy; risk limited to premium, upside unlimited.
• Put buyer: right to sell; risk limited to premium, profit increases as price ↓.
• Writer (seller) of call/put: obligation to fulfil if exercised; receives limited premium but faces potentially unlimited loss (call) or large loss (put).
• Summary table:
  • Buyer: right ✓ / obligation X
  • Writer: right X / obligation ✓

Option Styles

• American: exercisable anytime up to expiry.
• European: exercisable only on expiry date.

Underlying Instruments (Bursa examples)

• OKLI: underlying = FBM KLCI Futures (FKLI).
• OCPO: underlying = 3-month FCPO futures.

Contract Specifications & Moneyness

• Expiry date, strike price $X$, premium $C\;\text{or}\;P$.
• Premium decomposition: $\text{Premium} = \text{Intrinsic Value} + \text{Time Value}$
• Moneyness (Call):
  • In-the-money (ITM): S>X
  • At-the-money (ATM): $S=X$
  • Out-of-the-money (OTM): S<X (reverse signs for put).

Risk-Reward Snapshot (Call Option)

• Buyer: Risk limited to premium; reward open-ended.
• Seller: Risk open-ended; reward limited to premium.

Payoff & Profit/Loss Equations

• Call Buyer: $\text{Payoff}=\max(0, S-X)$; $\text{Profit}=\text{Payoff}-C$
• Call Writer: $\text{Profit}=C-\max(0,S-X)$
• Put Buyer: $\text{Payoff}=\max(0, X-S)$; $\text{Profit}=\text{Payoff}-P$
• Put Writer: $\text{Profit}=P-\max(0, X-S)$

Basic Numerical Illustrations

1. European Call (J&J)
   • $X=\text{RM}89,\; C=\text{RM}2.17$
   • Price ↑ to RM94 ⇒ Payoff = RM5; Net profit = $$5-2.17=\text{