set 2 principles

8/3/2019 Set 2 Principles

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Principles

Dr Catherine S F Ho 1


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Definition and Types

Physical delivery vs Cash Settlement

Principles of hedging and speculation

Types and Positions



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DEFINITION OF FUTURES CONTRACTS

standardised legal agreement to buy or sell a

commodity or financial instrument at a specifiedprice, at a specified time in the future



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REQUIREMENTS FOR A VIABLE

FUTURES MARKETS

A deep market

Commodity must be in abundant

supplyCommodity must be easily graded

Prices must be free to fluctuate

Prices must be reported publicly



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THE FUTURES CONTRACT

Standard Features: Physical delivery or cash settlement

Expiry date

Contract months

Contract size

Price Quotations

Grade

Underlying instruments



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HEDGING

CASH MARKET FUTURES MARKET



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HEDGING

Taking a position in the futures market

to offset the loss in the cash



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TYPES OF HEDGEANTICIPATORY

- Taking the same position in the futures market

now that you intend to take in the cash marketlater

HEDGING CURRENT MARKETPOSITION/PORTFOLIO HEDGE

- Taking an opposite position in the futures marketthat you have already taken in the cash market



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WHY HEDGE?

To preserve and promote wealth by reducing exposureto financial and commodity price movements,catastrophes, variable operating costs and income



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ADVANTAGES

Liquid and central market

- high volume and turnover lead to the ease of entering andgetting out of the market

Leverage- pay a small capital outlay to have a sizable value of contracts

Positions may be close out- contracts can be close out at any time when required

Convergence of futures and cash prices- at maturity futures price should be equal to cash price



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DISADVANTAGES

Standardized contracts

- since it is standardized, therefore mayunderhedged or overhedged.- e.g. RM1.8million portfolio

Initial and variation margins- traders may not feel comfortable with thepayments of margins

Forgo benefits of favourable movements- would not be okay if what the trader anticipatesdid not materialize



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STEPS IN IMPLEMENTING A HEDGE

DETERMINE THE TYPE OF HEDGING

DETERMINE THE NUMBER OF CONTRACTSNEEDED TO HEDGE

DETERMINE THE CONTRACT MONTHS

DETERMINE THE EFFECTIVE BUYING OR SELLINGPRICE



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HEDGE IMPERFECTIONS

BASIS RISK risk that futures and cash instrument pricesare not equal at expiry or are not perfectly correlated

- delivery basis difference between the cost of deliveryof futures and cash instrument

- grade basis difference between the grade of futures andcash instrument

- location basis difference between prices in differentmarkets or areas

AMOUNT HEDGED hedge may not cover exactly the

amount of the cash instrument TIMING differences in timing of futures and cash

instrument



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SPECULATING WITH FUTURES

Speculators provide liquidity to a market and

continuous trading Speculators are attracted to the market because of:

high leverage

low transaction costs and commission as

opposed to stock or property market

large and small traders have equal access to the

market

minimal administrative works



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TYPES OF SPECULATORS

OUTRIGHT POSITIONS: buy low sell high

Scalpers goes for minimum price fluctuations on heavyvolumes, taking small profits or losses, rarely holdovernight positions

Day traders

does intraday trading and differs fromscalpers in that his volumes are smaller

Position traders looks are long term price trends, mayhold a position for days, weeks or months and only close

out when prices are favourable



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SPREAD TRADING:

simultaneous buy and sale of related contracts inorder to profit from a change in the differencebetween the two futures prices

Intracommodity spread

Same futures contracts but different delivery months Intercommodity spread

Different futures contracts, same delivery months Different futures contracts, different delivery months



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INTRACOMMODITY SPREAD

In a normal market, the nearby month sells at adiscount to the distant delivery

Therefore, trader buys the nearby maturity andsells the distant maturity in anticipation of a

narrowing in the spread difference

EXAMPLE

Buy 5 Mar CPO at 1100, sell Jul CPO at 1130

Later sell 5 Mar CPO at 1109, buy Jul CPO at 1134



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INTERCOMMODITY SPREAD

Involves the simultaneous purchase and sale of

different, but related, commodities in the same ordifferent markets and in the same or differentdelivery months

ExampleBuy March corn on the CBOT and sale of Marchoats on the CBOT.

or

Buy June CPO on the Bursa Malaysia DerivativesExchange and sale of June Soybean oil on theCBOT



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ARBITRAGE

Simultaneous purchase and sale of the same

instruments in two different markets to profit frommispricing

Example buy physical gold and sell gold futures

Need to determine whether the futures price is tradingat itsfair value.



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Cost of carry model

irescontractfutureswhentimet

storageoftc

productcashtheonyieldy

ratefreeriskr

pricecashS

pricefuturesF

where

ycrSF t

exp

(%)cos

)1(



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Cost of Carry Calculation

EXAMPLE

If the cash price for gold is US$410 per oz, storagecosts for 1 year is US$8 per oz and the risk-freerate is 6%, what is the fair value price of a gold

futures contract expires three month from now?

92.417

)]410/8[06.01(410 12/3

FV



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Exercise If the cash price for CPO is RM3210 per MT,

storage costs for 1 month RM2 per MT and the

risk-free rate is 6%, what is the fair value price of aCPO futures contract expires three month fromnow?


set 2 principles

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