Derivatives Notes

INTRODUCTION TO DERIVATIVES

CHAPTER OUTCOMES

• Definition and Overview of Derivatives

• The Exchange (Bursa Malaysia Derivatives Berhad, BMDB)

• The Clearing House (Bursa Malaysia Derivatives Clearing)

• Intermediaries in Bursa Malaysia Derivatives Berhad

• Users and Participants of Derivatives Market

WHAT ARE DERIVATIVES?

• Something that is based on another source.

• 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).

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.

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 or financial instruments will be made in the future.

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.

• 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.

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

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:

  • Membership to the Exchange

  • The administration of the Exchange

  • Member & customer relationships

  • Trading practices

EXCHANGE TRADED VS. OVER THE COUNTER (OTC) DERIVATIVES

• Differences between exchange traded market & OTC

CLEARING HOUSE

• The clearing house that clears the contracts traded in BMDB is known as the Bursa Malaysia Derivatives Clearing Bhd (BMDC) 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.

• 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.

• 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.

INTERMEDIARIES IN BM DERIVATIVES

• FUTURES 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

    • Providing basic accounting records

    • Advising customers in their trading programs

• FUTURES 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.

• FUTURES FUND MANAGERS

  • Companies that carry out a futures fund management business.

  • Specialize in managing funds that trades in future & options

  • Employees of futures fund managers are called futures fund manager representative

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

• 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.

• ARBITRAGEURS

  • 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.