This research investigates the demand of derivatives investment by Malaysian. On the whole the main purpose of this dissertation is to study, analyse and discuss about the usage of derivatives by Malaysian company or individual resident. The research paper is divided into five chapters.
Chapter 1 introduces derivatives and identification of the research problems. Research objectives and questions are given briefly.
Chapter 2 provides an overview of the literature reviewed throughout the research. A detailed description by past researchers is presented. The further detail of each derivative contract are summarised.
Chapter 3 deals with the work flow of this study. The research methodologies includes research design and procedure, data collection method, and statistical data analyses method. Data collection from secondary data is analysed to form a theoretical framework.
Chapter 4 present the analysis and result of research topic. Tables, diagrams, charts are use to illustrates the findings.
Finally, Chapter 5 concludes the dissertation with summary all of the chapters.
A derivative is a financial instrument that is derived from assets, indexes, events, value or condition (known as the underlying asset). Rather than trading or exchanging the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. (David, 2003)
From definition taken from International Accounting Standards 39 (IAS39) Financial Instruments Recognition and Measurement, a derivative is a financial instrument whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rate, a credit rating or credit index or similar variable. (IAS, 2009)
Forward contracts, futures contracts, options and swaps are the most common types of derivatives. Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative. (Khanna, 2010)
The research problem of this study is to uncover the derivative investment as a financial instrument for business and gaining capital. The usage of derivatives is getting larger nowadays. However, there is some criticism regarding the derivative in negative aspect as well.
The following are the specific objective to achieve under this research
Questions that are bound to be answered throughout the research are:
Scope of Study
The scope of study for this research focuses on the derivative instruments.
Significance of Study
The significance of this study is to give the investors an idea as how the derivative instruments work in the business world. It also a study that helps businessman to reduce their risk and speculator to gain short-term money through derivatives.
Introduction of Derivatives
The first derivatives contract was listed in the year 1865 by the Chicago Board of Trade (CBOT) in USA. Those “exchange traded” derivatives contracts were called “futures contracts”. In April 1973, the Chicago Board of Options Exchange (CBOE) was set up for the purpose of options trading. The Standard & Poor’s 500 Index in USA currently is the most popular stock index futures contract in the world. (HSBC Invest Direct, 2010)
There are two distinct groups of derivative contracts, which tell apart the way they traded in the market.
There are few major derivative contracts which consist of forward, future, option and swap contract.
A forward contract is a contract negotiated at present that gives the contract holder both the right and full legal obligation to conduct a certain asset transaction at a specific future time, amount, price and other terms. (Schweser, 2002)
The party to the forward contract that agrees to buy the financial or physical asset has a long forward position and is called the long. The party to the forward contract that agrees to sell or deliver the asset has a short forward position and is called the short. (David, 2003)
For instance, Lam Soon Company signed a contract under which they agree to buy a tonne of crude palm oil (CPO) from their supplier 30 days from now at a price of RM2,500. Lam Soon Company is the long and the supplier is the short. Both parties have removed uncertainty about the price they will pay or receive for the CPO in the future date. If 30 days from now CPO are trading at RM2,580 per tonne, the short (supplier) must deliver the CPO to the long (Lam Soon) in exchange for a RM2,500 payment. If CPO are trading at RM2,420 on the future date, the long must purchase the CPO from the short for RM2,500, the contract price.
Forward contract is usually negotiated directly between the two parties, therefore it is an OTC market forward contract. The forward contracts have the advantage of being flexible (the parties design the contract to meet their specific needs). However, Stalla (2000) had concluded that forward contracts have three major disadvantages:
They are illiquid. Because the terms of a forward contract are usually designed to meet the specific needs of the contracting parties, it is difficult for either one of them to close out its side of the contract, either by selling it to a third party or by getting the counterparty to cancel the agreement without demanding an excessive buyout price.
A futures contract is a forward contract that has been highly standardised and closely specified. As with a forward contract, a futures contract calls for the exchange of some goods at a future date for cash, with the payment for the goods to occur at the future delivery date. The purchaser of the contract is to receive delivery of the good and pay for it, while the seller of the contract promises to deliver the goods and receive payment. The payment price is determined at the initial time of the contract. (Adhar, 2006)
Futures contracts are usually traded on futures exchanges (ETD), rather than in an OTC environment. Hence, futures contracts are unique forms of forward contracts that designed to reduce the disadvantages of forward contracts. The future contracts terms have been standardised so that can be traded in a public marketplace. Due to standardisation, futures contracts are lesser flexible than forward agreements, hut it also makes them more liquid. (Copeland, et al., 2004)
According to Schweser (2006) points, in order to safeguard the clearinghouse, which act as the buyer to every seller and the seller to every buyer, the exchange requires traders to post margin and settle their accounts on a daily basis. Before trading, the trader must deposit funds, called margin with their broker (who, in return, will post margin with the clearinghouse). The purpose of margin is to ensure that traders will perform their contractual obligations.
There are three types of margin. The first deposit is called the initial margin which had been explained above. Any losses for the day are removed from the trader’s account and any gains are added to the trader’s account. If the margin balance in the trader’s account falls below a certain level (called the maintenance margin), the trader will get a margin call and have to deposit more money (called the variation margin) into the account to bring the account back up to the initial margin level. (Stalla, 2000)
For instance, Lam Soon buys a 30 days future contract of CPO at RM2,500 per tonne. The initial margin was RM2,500. The next day the price of CPO plummetsRM50. Therefore Lam Soon has just lost RM50. At the end of the day, the daily settlement process marks Lam Soon’s margin account to market by taking RM50 out of the account leaving a balance of RM2,450. Now, assume the maintenance margin level is at 70%. If Lam Soon’s margin balance falls to or below RM1,750, Lam Soon gets a margin call and has to bring their account back up to the initial RM2,500 level.
There are several advantages to using forward or futures contracts as a substitute for trading in the spot markets of commodities: (Sorid, n.d)
The primary disadvantage of using futures contracts for speculative trading would involve a great deal of leverage, so that large losses can occur. In effect, holding a futures position with only the margin requirement on deposit in a brokerage account is the same thing as having purchased the underlying asset “on margin.” Another closely related disadvantage is that futures (but not forward) contracts subject the trader to margin calls to meet daily settlement obligations. This requires participants to have a cash reserve that can be drawn upon to meet these demands for additional cash. (Sorid, n.d)
According to the Chicago Board Options Exchange (CBOE) 2008, an option is a contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.
The owner of a call option has the right, but not the obligation to purchase the underlying good at a specific price for a specified time period. While the owner of a put option has the right, but not the obligation to sell the underlying good at a specific price for a specified time period. To qualify these rights, the options owner has to pay a premium to the seller of the option for buying the option. (CBOE, 2008)
The seller of the option is called an option writer. Options have four possible positions: (CBOE, 2008)
In these contracts, the rights are with the owner of the option. The buyer that pays the premium receives the right to buy or sell the underlying asset on specific time and price. The writer or seller of the option receives payment and obligates to sell or purchase the underlying asset as agreed in the contract of the option owner. (Akmeemana, n.d.)
For instance, BAT share is selling at RM50 while its call option is at RM10. The call option can be exercised for RM45 with a life span of 5 months. The exercise price of RM45 is called the option’s strike price. The RM10 price of the option is called the option ‘s premium.
If the option is purchased for RM10, the buyer can purchase the stock from the option seller over the next 5 months for RM45. The seller, or writer of the option gets to keep the RM10 premium no matter what the stock does during this time period. If the option buyer exercises the option, the seller will receive the RM45 strike price and must deliver to the buyer a share of BAT stock. If the price of BAT stock falls to RM45 or below, the buyer are not obliged to exercise the option. Note that the option holders can only exercise their right to act if it is profitable to do so. The option writer, however, has an obligation to act at the request of the option holder.
A put option is the same as a call option except the buyer of the put has the right to sell the put writer a share of BAT at any time during the next five months in return for RM45.
The owner of the option is the one who decides whether to exercise the option or not. If the option has value, the buyer may either exercise the Option or sell the option to another buyer in the secondary options market. (Tatum, 2010)
For short-term investment horizons, options trading can produce lower transaction costs than the outright purchase and sale of the underlying assets themselves. Besides, options can he used to execute some tax strategies. (Skousen, 2006)
A swap is an agreement between two or more parties to exchange sets of cash flows over a period in the future. The parties that agree to the swap are known as counterparties. The cash flows that the counterparties make are generally tied to the value of debt instruments or the value of foreign currencies. Therefore, the two basic kinds of swaps are interest rate swaps and currency swaps. (Schweser, 2006)
Unlike the highly structured futures and options contracts, swaps are custom tailored to fit the specific needs of the counterparties. The counterparties may select the specific currency amounts that they wish to swap, whereas exchange traded instruments have set values. Similarly, the swap counterparties choose the exact maturity that they need, rather than maturity dates set by the exchange. This flexibility is very important in the swap market, because it allows the counterparties to deal with much longer horizons than can be addressed through exchange-traded instruments. Also, since swaps are not exchange traded, it gives the participants greater privacy, and they escape a great deal of regulation. (Hodgson, 2006)
According to Hodgson (2996), the advantages of swap agreements over conventional traded derivatives can be summarised as below:
The disadvantages of swaps include:
The Demand of Derivatives
Based on the statistics of the Bursa Malaysia Derivatives Berhad, the total exchange of derivatives during the year 2009 was up to 6,137,827 contracts. The crude palm oil futures (ETD) is the most liquid future in Malaysia, total of 4,008,882 contracts with average of 334,074 contracts traded monthly during year 2009. (Bursa Malaysia, 2010)
Figure 2.1 shows the monthly price traded and the monthly volume of crude palm oil futures (FCPO) traded in Bursa Malaysia from year 1985 until March 2010. The green colour bar represents the price close on the month end was above the open price open on the beginning of the month, while red colour bar indicates the closing price is below the open price.
Figure 2.1 indicates that there was less transaction traded during the eighth decade of the 20th century until 2002. The number of FCPO contract traded keep on increasing especially start from year 2002, and is quite popular in recent year, the volume of transaction exceeded 150,000 contracts each month. FCPO is extremely high volume in 2008 because the global oil price is at its peak at USD145 per barrel. FCPO traded at its pinnacle in November 2006 which recorded 360,650 contracts in a month. This showing that the FCPO is high in demand in Malaysia as compare to previous years.
Figure 2.2 shows the history chart of FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures (FKLI) traded in Bursa Malaysia from December 1995 until March 2010. There was a high trading volume during the 1997 Asian Financial Crisis due to the high fluctuate of the Kuala Lumpur Composite Index (KLCI). 148,318 future contracts were traded in September 1998.
There were at least 40,000 future contracts traded in the following years of 1998. The volume traded increasing rapidly in 2007 as Malaysian economy recovers. KLCI went as high as 1400 points during the last 3 years. 302,321 future contracts were trade in August 2007, which is the highest volume recorded in history.
Based on Figure 2.2 trading volume trend, it can be concluded that speculators were heavily involve in trading FKLI in 1997, where the Asian Financial Crisis tragedy occurred and in its peak in 2007 . KLCI fluctuation was elevated during these two event (circled in the chart).
For the global market, the market for options developed rapidly in early 80s. The number of option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. According to the Bank for International Settlements, the total OTC derivative outstanding notional amounted to USD605 trillion as of June 2009.
Factors That Influence Derivatives Trading
Mike Singh (2010) said that trading derivatives will have lesser risk than other trades because investor are not buying into the company or buying the underlying product. Instead, the risk is placed on performance. Due to its low risk factor, investment and commercial banks, end users such as floor traders, corporations, and mutual and hedge funds, are major types of firms that utilize derivatives.
A much lower initial investment start up in derivatives trading, derivatives give an edge to those who decline or do not want to invest as much as is required to purchase stock. Derivatives can be a good way to balance ones total portfolio by spreading the risk throughout a variety of investments, rather than putting all eggs into a basket.
Besides that, trading derivatives can be a good short term investment. Compared to some stocks and bond, derivatives is an financial instrument that can pay off in a shorter time frame such as days, weeks, or a few months. Stock and bonds are long-term investments and may over the course of many years. As the shorter turnaround time, derivatives can be a good way break into the market and mix short and long-term investments. (Siems, 1997)
Numerous resources are available for learning about derivatives trading and many options are available. Hence derivatives are variety and flexibility, this point of view was supported by Mike Singh, 2010. Derivatives can derive profit from changes in equity markets, currency exchange rate, interest rates around the world. It also include the commodities changes in global supply and demand such as precious and industrial metals, agricultural products, and energy products such as petroleum and natural gas. This show that derivatives trading are available on a global scale. Getting involved in the global economy opens international options that may not be available through the traditional stock market.
From the points given above, he concluded that there are three reasons for derivatives trading. First, trading derivatives are lesser risk than other trades. Second, trading derivatives are a good short term investment. Third, trading derivatives are variety and flexibility. Hence, derivatives trading may be a good trading option if someone are looking outside of trading traditional stocks and bonds.
The International Swaps and Derivatives Association, Inc. (ISDA) announced the results of a survey done on the derivatives usage by the world’s 500 largest companies. According to the survey, 94% of these companies use derivative instruments to hedge and manage their financial risks in business. The foreign exchange derivatives are the most widely used instruments with total 88% of the sample, followed by interest rate derivatives which is 83% and commodity derivatives.
There are two benefits which are most widely recognised attributed to derivative instruments, risk management and price discovery. Risk management could be the most vital purpose of the derivatives market. Derivatives also used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect, bearing extra risk by speculations. (Kuhlman, 2009)
Price discovery is the prediction of information about future cash market prices through the futures market. There is a relationship between an asset’s current (spot) price, its futures contract price, and the price that people expect to prevail on the delivery date. By using the information contained in futures prices today, market observers can form estimates of what the price of a given commodity will be at a certain time in the future. Futures markets serve a social purpose by helping people make better estimates of future prices, so that they can make consumption and investment decisions more wisely. (Sorid, n.d)
The derivatives market are broadly classified into three uses:
Hedging is a way to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entity’s other risks and uncertainties. (Elliot & Elliot, 2005) One reason why companies attempt to hedge these price changes is because they are risks that are peripheral to the central business in which they operate. Hedging also refers to managing risk to an extent that makes it bearable. (Kameel, 2008)
Traders can use derivatives to hedge or mitigate risk in the stock market. Entering into a derivative contract can cover part or all of the losses if the value of their underlying position moves in the opposite direction.
For equity forward contracts, where the underlying asset is a single stock, a portfolio of stocks, or a stock index, work in much the same manner as other forward contracts. An investor who wishes to sell 100 shares of BAT stock 90 days from now and wishes to avoid the uncertainty about the stock price on that date, could do so by caking a short position in a forward contract covering 100 BAT shares. A dealer might quote a price of RM48 per share, agreeing to pay RM4,800 for the 100 shares 90 days from now. The contract may be deliverable or settled in cash as described above. The stock seller has locked in the selling price of the shares and will get no more if the price (in 90 days) is actually higher, and will get no less it the price actually lower. (Sharma, 2009)
For equity future example, an individual stock trader can minimise the stock trading risk by hedging using futures market (Exchange-traded derivatives). A stock trader is extremely aware of economy downturn. If the trader expected an economy downturn is coming which will cause the share price to drop, the trader can protect against down fall of stocks equity by opening a short position of the FTSE Bursa Malaysia KLCI Futures (FKLI) to hedge against his stock portfolio. So if the economy downturn does happen, the trader will gain profit from the FKLI. However, there will be a loss if the trader close the position of the stock during the economy downturn, but the gain from the FKLI will cover some or over the losses from the stock market. Thus, this can reduce the risk by FKLI futures hedging. (Copeland, et al., 2004)
For stock option contracts, one call priced at RM6 with a strike price of RM30 gives the holder the right to purchase 100 shares of the stock at RM30 per share until the exercise date. The contract has a money value of RM600 (RM6 x 100 shares). For put options. the concepts are the same, except that the option gives the holder the right to sell 100 shares of the stated stock at RM30 per share through the exercise date.
Commodity is a physical substance which there is demand, such as basic resources and agricultural. The most popular commodities in Malaysia include CPO, gold, tin, rubber and latex. (Amadeo, 2003)
For instance, an airline company which the fuel is the biggest cost item for an airline taken care of, might want to get protection against the fuel price crisis. The airline company might enter into a future contract to hedge the fuel price. They will sign up a future contract with the fuel supplier (OTC derivative), promising that they will buy a certain amount of fuel at a certain price for the next certain months. The contract will definite the price that the airline company to pay for buying the fuel in future. In case the fuel price go higher than the contract price, then the fuel will have a cheaper price. If the fuel price gone down without the airline company expectation, which mean the contract price is higher than the market price, in that incident, the airline company might not want to exercise the contract price. In return, the airline company need to pay certain of fund to the fuel supplier as the contract fee. (Larry, 2005)
Malaysian Airline System Berhad (MAS) announced a RM1.34 billion fuel hedge gain in the second quarter ended 30 June 2009. (Francis, 2009) Idris Jala (2009), the Managing Director and Chief Executive Officer of Malaysia Airlines said that he had decided not to unwind the fuel hedges so that the company can remain protected against the volatile fuel prices. MAS had hedged 47% of its fuel requirement at USD103/ bbl WTI for the year ended 2009 from 31 March 2009. Further highlighting the volatility of fuel prices, the fuel price increased 47% since April 2009, those airlines that did not hedge will be affected by the fuel price increasing, said Idris Jala, 2009. While MAS fuel bill increasing in tandem with the fuel price, MAS total fuel bill will be lower as the gains from the fuel hedges will partly offset the higher fuel cost.
Foreign exchange (Forex) Hedging
In international trading, dealings with forex play a significant role. There will be a significant impact on business decisions and outcomes if got any fluctuations in the forex rate. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Therefore, companies will use forex hedging with forwards, future, option. (Joseph & Nathan, 1999)
Forex hedging with forwards
Forex forward rate is an agreement between two parties (OTC derivatives) to fix the exchange rate for a future transaction. In Malaysia, there are some banks do provide Forward Rate Agreements (FRA) service such as Bank Islam Malaysia, Maybank, EON Bank Group, CIMB Bank Group, HSBC Bank Malaysia, etc. A company simply transfer the risk to the bank when they entering into a FRA with a bank. Of course the bank internally will do some kind of arrangement to manage the risk. (Currencies Direct, 2010)
For instance, a Malaysian construction company, Ban Lee Hin Engineering & Construction Sdn Bhd just won a contract to build a bridge road in Philippines. The contract is signed for 10,000,000 Peso and would be paid for after the completion of the work. This amount is consistent with Ban Lee Hin minimum revenue of RM750,000 at the exchange rate of RM7.50 per 100 Peso. However, since the exchange rate could fluctuate and end with a possible depreciation of Peso, Ban Lee Hin enters into a forward agreement with Philtrust Bank in Philippines to fix the exchange rate at RM7.50 per 100 Peso. The forward contract is a legal agreement, and therefore constitutes an obligation on both parties. The Philtrust Bank may have to find a counter party for such transaction, either a party who wants to hedge against the appreciation of 10,000,000 Peso expiring at the same time, or a party that wishes to speculate on an increasing the value of Peso. If the Philtrust Bank itself plays the counter party, then the risk would be borne by the bank itself. By entering into a forward contract, Ban Lee Hin is guaranteed of an exchange rate of RM7.50 per 100 Peso in the future no matter of what happens to the spot rate of Peso. If Peso were to actually depreciate, Ban Lee Hin would be protected. However, if it were to appreciate, then Ban Lee Hin would have to forego this favourable movement and hence bear some implied losses. Even though this favourable movement is still a potential loss, Ban Lee Hin proceeds with the hedging since it knows an exchange rate of RM7.50 per 100 Peso is consistent with a profitable venture. (Kameel, 2008)
Forex hedging with futures
The futures hedging eventually overcome some of the shortcomings of the forward hedging. Both futures contract and forward contract are almost similar, but forward contract is much more liquid because it is traded in an organised exchange trading market – the futures market, which is ETD derivatives. It is similar with buying shares in the stock market where standardised contracts are bought and sold. The futures contract is also a legal contract just like the forward, but the obligation can be eliminate before the expiry of the contract by making an opposite transaction. For futures hedging, the trader needs to buy futures contract if the trader expect there will be appreciation of the currency value, or the trader needs to sell futures contract if the trader expect there will be depreciation of the currency value. (Lewent, et al., 1990)
Consider the earlier bridge road constructing in Philippines example, beside forwards, Ban Lee Hin could involve in futures hedging by selling Peso futures to hedge against Peso depreciation. Assuming Ban Lee Hin now hedge against Peso currency by selling Peso futures at RM7.50 per 100 Peso, which the contract size amounting to RM750,000. On the payment day after the completion of work, the Peso rate go against the interest of Ban Lee Hin and dropped in value to RM7.20 per 100 Peso. Ban Lee Hin would then close the futures contract by buying back the contract at this new spot rate – RM7.20 per 100 Peso. Ban Lee Hin gain a future profit of RM30,000 for the contract which bought from RM7.20 per 100 Peso and sold it for RM7.50 per 100 Peso. However, in the spot market Ban Lee Hin gets only RM720,000 when it exchanges the 10,000,000 Peso contract value at RM7.20 per 100 Peso. Eventually, the total cash flow is RM750,00 as well which derive from RM720,000 from spot exchange rate and RM30,000 profit from futures contract.
One of the advantage of using futures hedging is the Ban Lee Hin can release itself from the futures obligation by buying back the contract anytime before the expiry of the contract. A trader needs to pay a deposit called an initial margin to enter into a futures contract. The trader would receive a margin call (also known as variation margin), requiring him to pay up the losses whenever his account makes a loss for the day when the losses hit certain percentage of the initial margin. (Kameel, 2008)
Advantages of futures hedging:
Liquid and central market – since futures is Exchange-traded derivatives (ETD), trader who has taken a position in the futures market can easily close position at any time.
Leverage – futures have a margin system, where a trader control on a large position with only a small initial deposit. If the futures contract with a value of RM100,000 has an initial margin of RM10,000 then a one percent change in the futures price which is RM1,000, would bring about a 10 percent change relative to the trader’s initial costs.
Disadvantages of futures hedging:
Initial and daily variation margins – the futures position is tracked on a daily basis, the trader would be required to pay up daily variation margins if got any daily losses. The initial and daily variation margins can cause some cash flow burden on traders.
Forego favourable movements – any profits or losses in the spot transaction would be offset by losses or profits from the futures transaction.
Forex hedging with options
Option is a more flexible instrument than futures. Forex option is a contract between two parties (OTC derivative) which is the buyer and the seller. The seller of the option needs to be compensated by paying the premium of the option, for giving the right to buyer to buy (call options) or sell (put options) a specified currency at a specified exchange rate, at or before a specified date. (Hong Leong Bank Malaysia, 2010)
For instance, a trader buys a January RM7.50 Peso call option for RM0.30. Therefore, the trader has the right to buy Peso for RM7.50 per 100 Peso before the contract expired in January. the RM0.30 that paid is the premium for this right, also known as strike price or the exercise price. If the Peso appreciates over RM7.50 per 100 Peso within the expired date, then the trader may exercise his right and buy it for RM7.50 per 100 Peso. If the Peso were to depreciate below RM7.50 per 100 Peso, then the trader may just let the contract expire without taking any action since he is not obligated to buy it at RM7.50 per 100 Peso. I the trader needs physical Peso while the rate depreciate, he may just buy it in the spot market at the new lower rate.
Consider again the earlier bridge road constructing in Philippines example, since the risk of Ban Lee Hin is the depreciation of Peso, Ban Lee Hin would need to buy put options in Peso. If Peso were to actually depreciate by the time Ban Lee Hin receives the revenue in Peso, then Ban Lee Hin would exercise its right and exchange its Peso at the higher exercise rate. However, if Peso were to appreciate instead, Ban Lee Hin would just let the contract expire and exchange its Peso in the spot market for the higher exchange rate. Therefore the options hedging allows traders to enjoy unlimited favourable movements while limiting losses. Unlike the forward or futures contracts where the trader has to forego favourable movements and there is also no limit to losses.
Advantages of options hedging:
Disadvantages of options hedging:
Expensive – Because options are much more flexible compared to forwards or futures, hence the price is the disadvantage.
The options market is simply an organised insurance market. One pays a premium to protect oneself from potential losses while allowing one to enjoy potential benefits. For instance, when one buys a car insurance, one pays its insurance premium. If the car gets into an accident, one gets compensated by the insurance company for the losses incurred. However, if no accident happens, one loses the premium paid. If no accident happens but the car value appreciates in the second hand market, then one gets to enjoy the upward trend in price. An options market plays a similar role. In the case of options however the seller of a option plays the role of the insurance company. (Sheffrin, 2003)
According to the derivatives usage survey 2009 done by International Swaps and Derivatives Association (ISDA), Malaysian company Petronas rank 95th of the usage of derivatives. Petrolnas is actively involved in Forex derivatives.
Ratnajoothy (2009) mention in the Star Business, saying that forex hedge is also an instrument that helps to mitigate the impact of the currency market volatility. Such forex contracts usually attract companies involved in international trade and require huge amount of foreign currencies for the business. Lee (2009) told the Star Business that by hedging forex risks, businesses and individuals could lock in one’s cost or preserve one’s margin of future forex receipts or payments in current ringgit terms.
Interest Rate Hedging
Interest rate option hedging
Interest Rates Option (IRO) gives the trader the right but not the obligation, to fix the interest rate on a future loan or deposit, for a pre-determined amount which starts on an agreed future date. It also mean to give the trader a right, but not obligation to lock in a predetermined fixed rate. A premium cost is payable upfront. (RHB Banking Group, 2009)
Interest rate swap hedging
Interest rate swap (IRS) is the exchange of one set of cash flows (based on interest rate specifications) for another. IRS is an agreement between two parties, but occasionally involves more than two, is a type of OTC derivatives. The intention of IRS is to standardised to the requirement of interest rate of the parties involved. IRS can be used by hedgers to manage their fixed or floating assets and liabilities. It also use to hedge against future rise or fall in interest rates. (Maybank, 2008)
The three main types of IRS explained by Parsani (2009) are:
Firm A has a floating rate loan from a lender. Firm A thinks that the floating interest rates will rise and hopes to avoid higher payments. Firm A entering IRS hedging by paying a fixed rate to Firm B. Firm B receives a fixed payment from Firm A and pays it a variable payment (floating rate) in return, which Firm A then pays to its lender. In this case, Firm B do so because probably thinks that floating rates will fall. If favourable movement goes to Firm B which the floating falling, Firm B will pay out less than the fixed amount it receives from Firm A, making a profit off the difference.
Floating-for-floating swaps – interest rate swapping of both parties have floating interest payments rates involved. The floating rates are based on different indexes, so each party is betting that their own original floating rate will raise and the opposite party original floating rate will fall, making a profit off the difference.
According to Ling (2010), speculation is the process of selecting investments with taking large risks, especially with respect to trying to predict the future, just like gambling, in the hopes of making quick, large gains.
Forward and futures contracts can be used for speculative purposes, just like any other item that can be bought and sold at different times and at different prices.
For instance, suppose a speculator believes that gold is going to rise from its current price of RM110 per gram to RM120 per gram. The speculator could buy the gold outright by purchasing 100 gram, which is the size of one contract for RM11,000 in the spot market. If the price does increase to RM120 per gram, a profit of RM1,000 is earned. This represents a return of 9.1% on the investment.
Alternatively, the speculator could enter into a 9-month futures contract for 100 grams of gold. If this contract were priced at RM115 and the spot price of gold were to rise quickly to RM120 per gram. The contract might rise to a price of RM125. By “buying” the futures contract at RM115 and closing it out at RM125. The gain will be RM1,000 as well with the future contract.
If only a RM600 margin deposit were needed to enter into this contract, the RM1,000 profit would represent a 167% return on this cash deposit with the advantage of leverage concept in future contract.
Option contract can use for speculate as well. Skousen (2008) showing that a speculator can buy the option at one price and selling it for another, in the hopes of making a profit. The value of an option is based on the difference between the spot price of the underlying asset and the strike price of the option. As a result, option prices can be highly volatile. Furthermore, they are relatively low priced, so that small changes in the price of the underlying relative to a fixed strike price, can produce substantial changes in the return on the amount invested in the option. Speculators like the potential for high returns on small investment requirements.
According to Fabozzi, et al. (2010), an arbitrage opportunity is the chance to make a riskless profit with no investment. In essence, finding an arbitrage opportunity is like finding free money. In arbitrage, arbitrageurs observe two identical assets with different prices. The arbitrageur will buy the cheaper one and sell the expensive one short. The arbitrageur can then deliver the cheap one to cover the short position. Once the arbitrageur take the initial arbitrage position, the arbitrage profit is locked in. The no-investment statement referenced in the test refers to the assumption that when the arbitrageur short the expensive asset, and given access to the cash created by the short sale. With this cash, the arbitrageur now have the money to buy the cheaper asset. The no-investment assumption means that the first person to observe a market pricing error will have the financial resources to correct the pricing error instantaneously all by themselves
Arbitragers bridge the gap of price between the two different markets and prevent the prices of forward or futures contracts from drifting too far away from their theoretical relationships to the spot prices of their underlying commodities. If forward or futures contracts or any other derivative instruments become too cheap relative to the spot prices of their underlying commodities, arbitragers will “buy forward” (take a long position in forward or futures contracts for the commodity) and “short the spot” (simultaneously take a short position in the commodity itself in the spot market). Being long and short the same commodity, even though the trade will occur in the future, means that they have no net investment in the commodity. However, they will profit when the mispricing between the two markets is corrected, whether the mispricing is corrected by the forward or futures price moving up or by the spot price moving down. This satisfies the condition of an arbitrage opportunity. (Fabozzi, et al. 2010)
If the forward or futures price is too high relative to the spot price of the underlying commodity, arbitragers engage in the reverse arbitrage to the one described above; they “sell forward” and “buy the spot.” This forces the forward or futures prices down and the spot price up, bringing the two markets back into proper alignment. (Tatum, 2010)
It should be noted that it is not always possible to sell a commodity short in the spot market. It might be difficult, for example, to borrow lumber in order to sell it short. Therefore, an arbitrager who discovers that a lumber futures contract is too cheap relative to the spot price of lumber may not be able to effectuate a riskless arbitrage, simply because he or she cannot sell the lumber short in the spot market to offset the establishment of a long position in lumber futures contracts. When riskless arbitrages are not possible, forward and futures contracts can remain mispriced. Such a situation is less likely to occur in the forward or futures markets for financial and precious metal assets (stocks, bonds, currencies, gold, silver, and platinum), because it is relatively easy to sell these assets short, thereby facilitating riskless arbitrages
According to Dolde (2010), arbitrage is an important concept in valuing (pricing) derivative securities. In its purest sense, arbitrage is riskless. If a return greater than the risk-free rate can be earned by holding a portfolio of assets that produces a certain (riskless) return, then an arbitrage opportunity exists.
Arbitrage opportunities arise when assets are mispriced. Trading by arbitrageurs will continue until they affect supply and demand enough to bring asset prices to efficient (no-arbitrage) levels. (Dolde, 2010)
A study done by Billingsley (2005) showing that there are two arbitrage arguments that are particularly useful in the study and use of derivatives.
The first is based on the “law of one price.” Two securities or portfolios that have identical cash flows in the future, regardless of future events, should have the same price. If A and B have the identical future payoffs, and A is priced lower than B, buy A and sell B. You have an immediate profit, and the payoff on A will satisfy your (future) liability of being short B.
The second type of arbitrage is used where two securities with uncertain returns can be combined in a portfolio that will have a certain payoff. If a portfolio consisting of A and B has a certain payoff, the portfolio should yield the risk-free rate. If this no-arbitrage condition is violated in that the certain return of A and B together is higher than the risk-free rate, an arbitrage opportunity exists. An arbitrageur could borrow at the risk-free rate, buy the A+B portfolio, and earn arbitrage profits when the certain payoff occurs. The payoff will be more than is required to pay back the loan at the risk-free rate.
Other Comparative Advantage
Below is an example given by Tunaru, et al. (2010) summarised in the CFA Digest regarding the reducing of borrowing costs between a US firm (D) and a German firm (M), one firm may have better access to a country’s domestic capital markets than another firm. The D firm may have access to the US capital markets but not the German markets, while the M firm may have access to the German markets but not the US markets. If each firm borrows locally and then exchanges the funds, they will both gain.
Consider they trade derivative by using fixed for fixed currency swap.
D can borrow in the U.S. for 9%, while M has to pay 10% to borrow in the U.S. M can borrow in Germany for 7%, while D has to pay 8% to borrow in Germany. D will be doing business in Germany and needs marks, while M will be doing business in the U.S. and needs dollars. The exchange rate is 2 marks equals one dollar. M needs one million dollars and D needs 2 million marks. They decide to borrow the funds locally and swap the funds, charging each other the rate the other party would have paid had they borrowed in the foreign market. The swap period is for 5 years.
Below is the cash flows:
M and D both go to their own domestic bank:
M borrows 2,000,000 marks, agreeing to pay the bank 7% or 140,000 DM annually. D borrows 1,000,000 dollars, agreeing to pay the bank 9% or $ 90,000 annually.
M swaps currencies with D.
M gets 1,000,000 dollars, agreeing to pay D 10% interest in dollars annually. D gets 2,000,000 marks, agreeing to pay M 8% interest in marks annually.
They pay each other the annual interest.
M owes D 100,000 dollars in interest to be paid on the settlement date. D owes M 160,000 marks in interest to be paid on the settlement date.
They each owe their own bank the annual interest payment.
M pays the German bank 140,000 DM (but gets 160,000 DM from D, a 20,000 DM gain).
D pays the U.S. bank $90,000 (but gets $100,000 from M, a $10,000 gain).
They both gain by swapping. (M is ahead 20,000 DM, and D is ahead $10,000)
In 5 years, they reverse the swap. They return the notional principal.
M gets 2,000,000 DM from D and then pays back the German bank.
D gets $1,000,000 from M and then pays back the US bank
The Criticism of Derivatives
Chance (2008) wrote in his book said that derivatives are “too risky,” especially to investors with limited knowledge of sometimes complex instruments. Because of the high leverage involved in derivatives payoffs, they are sometime mistakenly characterised as a form of legalised gambling.
According to Siems (1997), he believed that derivatives create risks under circumstances of uncontrollable and not well understood. Some critics liken derivatives to gene splicing: potentially useful, but certainly very dangerous, especially if used by a neophyte or a madman without proper safeguards.
The derivatives market is not capitalism but a casino for speculators. It is essentially a bet, unlike betting on horses, football teams, or a hand in blackjack. Some will argue that buying a stock is a bet. But there is a key difference. A stock provides capital for a business. A derivative does not. Naturally, the derivatives market dwarves the stock market by a ratio of 3 to 1. Needless to say, the big money is in trading derivatives. (Broadway, 2010)
Theoretical framework is used to combine individual indicators into a meaningful composite and provide a basis for the selection of components. It allows us to make a better prediction. There is a clear relationship between independent and dependent variables as shown as below.
The theoretical framework of this research consist of two variables, which are independent and dependent variable. The independent variable is defined as the probable cause of the changes in the dependant variable (Borgatti, 1999). Dependant variable is the key factor that has been looked into to explain or predict if they are affected by some other factors.
This research attempt to show the factors which attracts Malaysian into derivatives investment. The independent variable in theoretical framework; hedge, speculation and arbitrage, is the three main factors which draw the involvement of Malaysian to invest in derivatives.
Data of this research was collected solely on secondary data. Most of the data basically collected from the internet with using the Google search engine on financial instruments websites, exchange company websites, books or article online and some other useful websites. Apart from this, some of the reading materials such as professional journals include the CFA Digest, CFA Magazine, Financial Analysts Journal were provided by Mr. Ooi who has been very helpful in this research.
Besides, the PTPL College library and the local public library are important sources to obtain secondary data where journals and books are freely available. In addition to that, current information and data can be referred from the latest financial books sold in MPH and Popular book store.
This qualitative basis research is conducted via desk research. The advantages of carrying out desk research is because of a lower costs, fast data availability and wide range of data. However in some circumstances, there are probability that some results could be out of date or incorrect.
The derivatives investment illustration; figures and chart are explored to demonstrate the demand trend of derivatives in Malaysia. Each derivative instrument are categorised to indicate the usage situation in different time frame. All derivative instruments are clustered under Hedging, Speculate, and Arbitrage basis.
All the research arguments are supported by secondary data. Tables, diagrams, charts will be used to explain the findings. Lastly, conclusion is given at the end of the report.
Overview of Findings
In this chapter, the demand of derivatives by Malaysian are based on the hedging, speculation and arbitrage basis which was interpreted in the theoretical framework. The conclusion of finding will be form on the last of this chapter.
There are plenty of Malaysian companies investing derivatives for hedging purposes, one of the derivative heavy user is Petroliam Nasional Berhad (PETRONAS). PETRONAS is vested with the entire oil and gas resources in Malaysia and entrusted with the responsibility of developing and adding value to these resources.
Table 4.1 shows the derivatives usage survey 2009 by International Swaps and Derivatives Association (ISDA). PETRONAS is ranked 95th globally for the derivative usage, forex hedging is the primary derivative for PETRONAS company. The forex hedging traded by PETRONAS is for trading of crude oil in the world market, sourcing for non-Malaysian crude oil for processing at PETRONAS’ refineries. Moreover, more than half of Malaysia’s crude production by PETRONAS is exported to foreign countries. Thus, hedging instrument is a necessity for PETRONAS company. (PETRONAS, 2010)
Other than PETRONAS, national carrier Malaysian Airline System Berhad (MAS) is heavily involved in fuel hedging. Hedges are essentially derivatives which airlines use to lock in a fuel price in advance to protect themselves from price volatility. An analyst estimates MAS using up to 16 million barrels of crude oil per year. (Tan, 2009)
MAS had hedged 60% of its fuel requirement for 2010 at about US$100 a barrel and 40% of its fuel needs at US$100 per barrel for 2011. In the fourth quarter for the year ended 2009, MAS posting a net profit of RM609.7mil after including a derivative gain of RM581.7mil compared with RM46.6mil recorded a year ago. (Leong, 2010)
However, there is no bullet proof method that can prevent loss, MAS posted a derivative account loss of RM202.1 million on the third quarter ended Sept 30, 2009 (3QFY09). According to a Bursa Malaysia filing 25 Nov 2009, the group’s derivative loss was incurred from foreign currency hedging contracts, interest rate-hedging contracts, and fuel-hedging contracts. (Yong, 2009)
Exchange-traded Derivative (ETD) Hedging
Bursa Malaysia Derivatives (BMD) is the sole exchange for the futures and options market in Malaysia established in 1930 and one of the largest bourses in Asia with almost 1,000 listed companies. BMD Berhad is the world’s largest derivative exchange operates most liquid and successful crude palm oil futures (FCPO) contract in the world. (Palmoil, 2009)
Figure 4.1 shows the FCPO monthly price and volume traded in Bursa Malaysia from year 2000 until March 2010. The arrow [a] indicates a steady rise of FCPO volume traded from the year 2000 until 2006 with exceeding 50,000 contracts per month. Beginning of year 2006 to mid of year 2008 (indicator [b] &[c]), there was a sharp demand of FCPO with recorded 360,650 contracts traded in a month of November 2006. This may due to investors predicting that there will be high appreciate of crude oil price in the coming years as shown in Figure 4.1 (Williams, 2007)
The price of FCPO went down significantly after the price peaked in mid of year 2008 [d]. The price rebounded in the year 2009 and maintained a high volume with an average 160,000 contracts per month. [e] & [f]
The high demand of FCPO was due to the suddenly appreciate of crude oil price globally during the year 2007-2008. Figure 4.2 shows the price of crude oil (red colour trend) from year 2000, the price of crude oil exceeded US$140 per barrel during mid of year 2008 due to imbalance in supply and demand. (Brown, 2008)
Figure 4.3 shows the history monthly chart of FKLI traded in BMD from year 1999 until March 2010. There were at least 40,000 future contracts traded along the years. There was a high demand of FLKI when the KLCI went as high as 1400 points in 2007. 302,321 FLKI contracts were traded in August 2007, the highest volume recorded in history.
Table 4.2 shows the monthly volume traded and open interest of both FKLI and FCPO from March 2007 until March 2010. The month volume column is the number of transaction closed position while the month-end open interest column means the number of contract which is still on floating, not yet close position.
Table 4.2 is translated into the following charts to show the total amount of volume traded plus month-end open interest.
Figure 4.5: FKLI Monthly Volume Plus Open Month-end Open Interest
Source: Redraw from Table 2, BMD, 2010.
Figure 4.6: FCPO Monthly Volume Plus Open Month-end Open Interest
Source: Redraw from Table 2, BMD, 2010.
Figure 4.5 and Figure 4.6 illustrate the demand of these 2 derivative remand high especially the FCPO which exceeded 300 thousand contracts since year 2009. The FKLI declines recently due to the economy in Malaysia performing well after recovering from financial crisis during 2007-2008. The number of hedging was reduced because investors are confident about the performance of Malaysia economy. (Ameer, 2010)
Figure 4.7 was drew by consolidate Figure 4.5 and Figure 4.6 to depict an overview of total derivative transaction closed position and open position for the year 2003 until year 2009. The derivative shows a strong demand with over 6 million contracts for 3 years consecutively.
Derivatives Market Demography
FCPO contracts is the main derivative product in BMD, followed by FKLI and FKB3. From the Chart 10, FCPO is increasing significantly from 49% in the year 2008 to 72% in 2009.
As stated in Chapter 2, there are 3 types of forex hedging which are commonly used that consist of forwards, futures and options. A comparison table is given below to differentiate the pros and cons of each contract.
Speculation involves an attempt to profit over the short term from fluctuating prices. As for the usefulness of derivative market today, investors will rather commit to short-term investment than long-term investment in futures and options contract. Instead of holding the share and get the dividends from the company, investors are more willing to earn contra profit from short-term investment (Deemer, 1999).
Speculator can trade FKLI to generate money when share market bearish. Short selling is not allowed for shares in Bursa Malaysia. Therefore, the trader can only make money trading shares when the share market goes up. However, short selling is allowed for FKLI, which means the trader can sell first at a higher price and buy back later at a cheaper price when the market goes down. FKLI can make money both when the market is up and when the market is down. (Anon., 2008)
Furthermore, trading FKLI has a higher leverage and profit potential. Apoint of movement in FKLI is RM50. For instances, a speculator predict Malaysia ruling government will lose their 2/3 majority in Parliament after the 12th General Election, the speculator short sell a contract of FKLI at a point of 1269 on 4pm Friday 7th March 2008, which was a day before the General Election. The prediction went to the favour of the speculator, he bought back the FKLI contract on Monday 10th March 2008 when the market opened the next morning. The KLCI depreciate, then open at 1163, immediately the speculator gain 106 point, which equivalent to RM5,300 in just 3 days. This example illustrate on Figure 4.10 below:
Nowadays, there is plenty of investment training company teaches recruit customer to speculate in futures and options market in Malaysia. These companies usually conduct their training in hotel where there a quite numbers of student participated. There is a demand for people who might consider speculation in the derivatives investment. (Khanna, 2010)
Figure 4.11 shows two types of FKLI users at a particular KLCI performance. Speculators exist all the time while hedgers comes in when the KLCI became unstable. During the year 2007 to 2009, there was extremely high volume of FKLI traded because hedgers hedge against their asset before crisis happen on year 2008. Meanwhile, there was a good chance for speculators to trade due to huge fluctuate of KLCI in short time. (Lee, 2008)
Due to the conservative nature of Malaysia market, arbitrage is less popular although it has the least risk. On top of that, arbitrage is an Over-the-counter Derivative which have high confidential and privacy involve, thus no arbitrage information was recorded in Bursa. (Skousen, 2006)
As arbitrage opportunities arise when assets are mispriced, the high efficiency of BMD make investor difficult to find arbitrage opportunity as well.
Conclusion of Findings
Malaysia is a pioneer in the CPO contract industry and Bursa FCPO which is now 27 years old is an established market leader. The BMD Berhad is the world’s largest derivative exchange operates most liquid and successful crude palm oil futures contract in the world as well. Thus, the demand of FCPO will sustain with strong demand. (Palmoil, 2009)
Lee (2008) said that the FKLI contract is a favourite investment by speculators, the high amount of volume traded in FKLI during high fluctuate of KLCI is the golden time for speculators to gain in derivative market.
The forex hedging is the essential instrument for those company which involve in international trade. With forex hedging, their risk of loss in currency will be minimise.
From the three basis of derivative, hedging is high demanded by Malaysian. Hedging user are mostly business company who hedge their asset to prevent huge loss Subsequently followed by speculating, which is the most popular for individual trader. The last is arbitrage which less welcome by Malaysian. (Ghosh & Clark, 2004)
This research has fulfilled its research objective with find out the factor and demand of derivatives by Malaysian. The derivative market is simply a tool that uses to hedge, speculate and arbitrage purpose, which will help investors to reduce their risk and meanwhile gain some capital on it.
However, derivative is not a bullet proof tool to prevent the risk. MAS too posted a loss of derivative trading as mentioned above. In fact, the derivative traders need to hold a comprehensive knowledge before they commit into any derivatives investment. Therefore, the knowledge can lead to the gain of investment. (Elder, 2002)
This research has fulfilled its research objective by uncovering real demand value of the derivatives investment in Malaysia. In Malaysia, derivative is simply a tool that used to hedge against losses that may incurred in future time. Many Malaysian based companies employed derivative to hedge their raw materials, currency rate and interest rate.
It is also good for speculating. It is much preferred tactic by an individual investor when compared to hedging or arbitraging. The latter are much more appropriate for business based companies. Nowadays, short-term investor selects trading future to speculate fast profit rather than buying conventional stock (Szakmary, et al., 2010)
Hedging, speculating and arbitrage are three main factors that influence Malaysian to invest in derivatives. Hedging and arbitrage carries the least risk while speculating has the most. Higher risk gives the possibility of a higher returns. There are no guarantees. Just as risk means higher potential returns, it too can cause a substantial loss. (Krantz, 2006)
Hedging is a good financial tool to minimise the business risk. However it could cause losses when trading derivatives without skill, knowledge and intuition. Nobody wants a business with deficit income, the derivative writer such as bank, have their own risk management internally. As a result, they have higher possibility to gain income from derivative traders. In order word, instead of getting protection from derivative, the derivative trader may lose the capital to the derivative writer. (Sinclair, 2008)
Forward, future, option and swap contract plays their own role in derivatives. Each of them have the pros and cons depending on certain situation. Hence the trader need to know very well the characteristic of each contract and apply them wisely. Knowledge and skill are needed to optimise the usage of derivatives.
Derivatives has been traded in Malaysia for the past few decades. However, based on the result from the findings, derivative is not highly demanded in the earlier time but are getting gradually increasing in recent years thanks to emerging of business economy. (Magiera, 2010) FCPO has a strong track record in Bursa Malaysia Derivatives, and still remain high in daily transaction volume. Bursa Malaysia Derivatives holds the largest market share of FCPO contracts in the world.
Lastly, derivatives do help many organisations to protect their risk, but may bring losses as well. In the business world, derivative is not a bullet proof protection. In fact, comprehensive knowledge and skills are still a necessity for derivatives investment.
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