CHAPTER 7: FUTURES DERIVATIVES

DERIVATIVES
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.

FORWARD CONTRACTS
A contract between two parties agreeing to carry out a transaction at a future date but at a
price determined today.
3 steps to a forward contract
1. Setting the price to be paid, exact specification of quality, quantity and delivery
logistics, such as time, date and place
2. Delivering the underlying asset from seller to buyer, and
3. Payment of cash from buyer to seller.

FUTURES CONTRACTS
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
Standardized contract would have specified:
1. quantity (or the contract size),
2. quality (or the grade) of the underlying asset,
3. delivery date (or the expiry date) and
4. location of delivery

KEY ELEMENTS IN FUTURES TRADING

1. Convergence of Futures and Cash Prices
Backwardation (Futures prices lower than cash prices)
Contango (Futures prices higher than cash prices)
2. Basis and Basis Risk
Basis the difference between cash price, spot price of financial instrument and
futures price
Basis risk futures price and cash prices are not perfectly related, so gains and losses
do not perfectly cancel out each other
It arises due to the mismatch of quantity, quality, maturity and location
3. Margins and Marking to Market
Initial margin initial amount that must be deposited at the beginning of contract
Additional margin/variation/maintenance margin payment that would have to be
paid to reflect the investors loss
4. Types of orders (market order, limit order, stop loss order)
5. The Clearing House
As intermediary in futures transactions to guarantee the performance of the parties
Novation role to assume the opposite side of transaction of each open contracts
respectively, minimizes the tendency of default by both seller and buyer
HEDGING WITH FUTURES CONTRACT
Types of Hedging:
1. Anticipatory Hedging
o Taking a futures position in anticipation of a later cash transaction (sell)
2. Hedging current market position
o Taking a futures position opposite to the current physical position held (buy)
ADVANTAGES
DISADVANTAGES
Minimum margin requirements
Not possible to match exactly the
allow traders to leverage
expiry date, amount and quality of
investments
commodity
Does not have to be held until
May prevent hedgers from
maturity (freely traded any time)
benefiting from favourable price
Low transaction costs
movement (if it is not as expected)
Minimize tendency of default by
Hard to determine the exact amount
both seller and buyer
to be hedge (all or portion)
Improve market liquidity and price
Difficult to choose delivery month
discovery role (long/short position)
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.
Types of speculating strategies:
1. Outright position
Takes a view of the change of the futures prices and speculate on it
2. Spread trading
Based on expectations of changes in relationship between several futures
contract
2

 The speculative traders in the futures market provide the depth and volume of trading that
allows hedgers and others to enter or exit the market easily.
Three types of speculators:
1. 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
2. Day traders
do intraday trading and on small volumes of trade (to take long or short
positions of a few contracts and would close-out their positions later in the
day when the prices have moved)
3. Position traders
look for long-term price trends and may hold over weeks, or months before
getting out

ARBITRAGING WITH FUTURES CONTRACT

The practice of taking advantage of price differentials across different markets
Simultaneous purchase and sale of the same instruments in different markets to profit from
temporary difference or inconsistencies
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.
COST OF CARRY MODEL

F S (1 r c y )t
where
F
S
r
c
y
t

= futures price for a contract with maturity from time t to T at maturity

= cash or spot price of the underlying asset
= annualized risk-free interest rate (a proxy for opportunity cost)
= annualized cost of storage (%) (inclusive of shipping, handling, shrinkage,
spoilage or damaged, etc)
= convenience yield on the cash commodity
= time to futures expiry expressed on yearly basis

SINGLE STOCK FUTURES

A future contract for an individually listed stock which track the movement of individual
underlying stock