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CHAPTER 2

CONCEPTS OF DERIVATIVES

Source: Rosalan Ali, Noryati Ahmad, Ho Soke Fun, (2007), “Introduction to Malaysian
Derivatives”, UPENA UiTM
Topic Outline
2.1 History and Development
2.2 Definition and Purpose
2.3 Participants
HISTORY & DEVELOPMENT
• Malaysian derivatives market includes the
trading of forward, futures, options and swaps
• MoF is the controller of Malaysian Derivatives
market
• Securities Commission is the regulator, BMDB
is the operator of the exchange
• BMDC is the clearinghouse – refer Bursa
Malaysia Regulatory Structure
HISTORY & DEVELOPMENT
• Msia joined derivative trading with the launch of
crude palm oil futures traded at the KLCE in Oct
1980.
• Thereafter, also trades agro based commodities
(rubber, tin and cocoa)
• 1995, trades in KLCI futures at KL Options and
Financial Futures Exchange(KLOFFE)
• 1996, KLIBOR was launched at the Malaysian
Monetary Exchange (MME)
• Trading futures at KLOFFE and MME regulated by
SC under MOF and cleared by MDCH
*Roles of Securities Commission-find out!
HISTORY & DEVELOPMENT
• Dec 1998, KLCE and MME were merged to form
Commodities and Monetary Exchange(COMMEX)
• Jan 1999, KLOFFE to be under management of
KLSE
• May 2001, KLOFFE and COMMEX merged known
as MDEX
• March 2002, Bond futures contract (MGS)
launched
• 2005, KLSE change to Bursa Malaysia Sec Bhd
(BMSB) and MDEX known as BMDB, MDCH
known as BMDC
DEVELOPMENT
• Bursa Malaysia Derivatives Berhad (BMDB) is a
wholly owned subsidiary of Bursa Malaysia Bhd
which provides, operates and maintains a futures
and options exchange.
• BMDB operates the most liquid and successful
crude palm oil futures (FCPO) contract in the world
• In the last quarter of 2009, BMDB entered into a
partnership with the Chicago Mercantile Exchange
(CME) Group; the world largest derivative exchange
which led to an acquisition of an equity interest in
BMDB.
DEVELOPMENT
• Trading of derivative products on Bursa
Malaysia comprising commodity, financial and
equity futures is carried out via multiple access
globally on CME Globex, the electronic trading
platform of the CME Group

Source: Bursa Malaysia Derivatives


What are derivatives instruments?
• …in simple explanation
• Derivatives instruments are financial instruments that
derive their value (price) from the value of an underlying
asset.
• Its value (price) entirely dependent on the value of its
underlying asset (either physical or financial assets)
• Example:
• Suppose I buy and hold a CPO Futures contract.
• The value of this contract will rise and fall as the value
(price) of spot CPO rises or falls
• Should the underlying asset (in this case is CPO),
rise/fall in value, then the value of CPO futures that I am
holding will also increase/decrease in value
Definition
• Derivatives could be defined as a contract
to buy or sell, which is set today, but will
be fulfilled at a stipulated date later.
• Derivative trading requires 2 instruments:
derivative instruments and physical
instruments (asset); and it also requires 2
markets, derivative market (DM) and
physical markets (PM)
Types Of Derivative Markets
1. Forward
• The oldest type of derivative market.
• Forward contract = agreement to buy or sell a
specified security at a specified price to be delivered
at the maturity date in the future.
• Agreement is privately arranged to fulfill the need of
both contracting parties (privately-negotiated
agreement)
• Close-out contract must be at the consent of both
parties.
2. Futures
• Simply defined as standardized and exchange
traded form of forward contract.
• Formal agreement between two parties to carry
out a transaction at future date
• This market develops due to the insufficient
trading requirement of forward transactions
(forward does not guarantee the fulfillment of the
contract)
• In Futures Market, there’s a 3rd party (Clearing
House) involve as the guarantor. It serves as the
buyer for seller and vice-versa.
3. Options - provides a right to one party (i.e
holder/buyer) and obligates the other party
(i.e seller)
• Option trading = contract that gives a right
(without obligation) to the buyer, while the
seller has an obligation (if requested by
the buyer) to buy or to sell a specified
security at specified price and time.
4. Swap = a private agreement to swap or
exchange a specified security for a
specified cash flow.
• Swap arises due to the need of
International Business between two
countries.
• Common types: currency swap & interest
rate swap
Purpose of derivatives markets*
1. Price Discovery
• The ability of derivatives market to reveal info
about future physical markets prices
• These represents the consensus (agreement) of
participants today about the prices of physical
instruments in the future
• Investors can discover the likely price in the
future by referring to the derivative price today.
• These price discovery enable investors to make
better investment & consumption decision.
2. Hedging Mechanism
• DM enables the physical owners of
commodity to manage their price risk
systematically
• Hedging with derivative instruments could
protect their trading profit from any
undesirable risk, and hence achieve their
price objective.
• Seller will sell futures today in anticipation of
falling price, buyer will buy futures today in
anticipation of rising prices.
Major Participants Of Derivative
Markets
1. Hedgers (risk management) – refers to
people/companies who wish to protect themselves or
“hedge” against adverse price movements using futures
• Hedgers do this by buying and selling futures contracts
to offset the risks of changing prices in the cash market
• They participate in the derivatives market hoping they
can transfer their price risk (avoid risk)
• In commodities markets, hedgers could be producers
(such as farmers, processor and etc) or consumers
2. Speculators (high volatility, high leverage) –
traders who are attracted to the market in view of
profiting from the volatility of prices
• Speculators do this by buying or selling
something, with anticipating future price changes.
• Speculators are more willing to accept risk
• Speculators take larger risks especially with
respects to anticipating futures price movements
in the hope of making quick and large gain
3. Arbitragers (safe opportunist)- process of
buying something at a place where its price
is low and selling it where its price is high
• The same asset can thus be bought and
sold simultaneously in two or more markets
to take advantage of the price difference

Source: 1. Dual licensing fast track programme (SIDC)


Source: 2. http://www.bursamalaysia.com/website/bm/derivatives/education/users2.html
Derivative Market Products
** What are the derivative products traded in Malaysia?
• http://www.bursamalaysia.com/market/derivatives/educat
ion/derivatives-basics/derivatives-market-landscape/
Exchange Traded Vs OTC Derivatives*
Features Exchange Traded Over the Counter

1. Market Listed & traded on an official Not Centralized - market


Place exchange participants trade over the
Centralized – BMDB phone, fax or electronic network
instead of a physical trading floor.
There is no central exchange or
meeting place for this market
2. Commission regulated, Self-regulated/informal market
Regulation governed by formal that have negotiable
rules/trading procedure, arrangements and customized
subject to governmental contracts.
regulation
3. Trading Standardized contract as Privately negotiated and traded
defined by exchange. directly between two parties.
Customization is not Terms & Condition set by two
possible parties (dealers) – Customization
is possible
Exchange Traded Vs OTC Derivatives
Features Exchange Traded Over the Counter

4. Transparency in Market clearing prices are Little transparency in


pricing transparent. pricing
5. Margin Legal requirement No legal requirement
Payment
6. Credit/Default Counterparty risk - Low Counterparty risk - High
Risk
7.Guarantee of Guarantees by clearing No guarantee of
Performance house against loss performance
resulting from the default
of one of the parties
8. Types of drvtv. Futures and Options Forwards and Swaps
traded

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