Structure of the Derivatives Market Finance Essay

Financial market for derivatives is called derivatives market. Derivatives market is a financial instrument that provides a safety tools and effective management risk of tools in financial futures and commodity products. Derivatives market also manages the fluctuation of stock index future market, option market, interest rate and stocks. With the establishment of derivatives market, it is hope that the investors and the corporations can manage their fluctuations of the market. The example of derivatives product in Malaysia such as KLOFFE, COMMEX and MDEX. Historically, the development of derivatives market in Malaysia started in 1980, as a Kuala Lumpur Commodity Exchange (KLCE), the first futures exchange in Southeast Asia establish offering palm oil futures contract. In 1995, Kuala Lumpur Options and Financial Futures Exchange (KLOFFE) were introduced. Its operation is for launching a stock index futures contract called KLSE Index Futures. In 1996, Malaysian Monetary Exchange (MME) was set up to facilitate the trading of three months KLIBOR futures contract and Crude Palm Oil (CPO) Futures. In 1998, KLCE combined with MME and changed its name to Commodity and Monetary Exchange of Malaysia (COMMEX). Next in 1999, the combination of two exchanges, KLOFFE and COMMEX to become Malaysia Derivatives Exchange (MDEX). MDEX trades four derivatives on that time, which is crude palm oil futures contract, KLSE Composite Index futures contract, KLIBOR futures contract and the KLSE composite options contract. In 2004, MDEX is known as Bursa Malaysia Derivatives Berhad until now. The exchange provide for trading of derivatives market. Derivatives market can be divided into two, which is exchange traded derivatives and over the counter. Exchange traded transactions are standardised contracts while over the counter transactions is more complex and be adapted to meet counterparties requirements. The most common types of derivatives market are interest rate swaps, options, futures and forward rate agreement. A forward rate agreement is a contract between two parties that determine the currency of exchange rate or the rate of interest, to be paid or received on a specific date beginning at a future start date. Futures contract is exactly the same as forward contract with one exception. With a forward contract, the buyer and seller realize gains or losses only on the settlement date. With a future contract, gains or losses are realized daily. Options contract is an agreement that gives the owner right, but not the obligation, to buy or sell (depending on the option type) some asset at a specific price for a specified time. Options can be divided into two, call options and puts option. Call option is gives the buyer (holder) the right to but (not obligation) an underlying asset. Puts option is give the buyer the right to sell an asset and they can decide whether it is profitable to sell the underlying asset accordingly. Last but not least for the type of derivatives market is interest rate swaps. Interest rate swap is an agreement between two parties that agree to exchange of interest rate cash flows. Interest rate swap is commonly used for hedging and speculating.

2.0 STRUCTURE OF THE DERIVATIVES MARKET

The structures that involve in derivatives market can be divided into four types, interest rate swaps, options, futures and forward rate agreement. The most common types used in Malaysia are options contract and futures contract. As we know futures contract is an agreement between a buyer and a seller to exchange a specified amount of cash for a specific asset at a future date. Futures contract is also a forward contract with the feature that gains and losses are realized each day rather than only on the settlement date. The differences of future contract and forward contract are that futures contract traded on exchange (the Malaysia Derivatives Exchange) with standardized agreement. The contract of futures contract was negotiated on a futures exchange which act as the intermediaries between two parties. The parties that agree to buy the underlying asset in the future contract, (the buyer) is said to be long while the party that agree to sell the underlying asset in future ( the seller) is said to be short The aim of the future contract is to minimize the risk default by the party. The types of futures contract available can be divided into two groups, commodity futures and financial futures. With a financial future, the underlying goods are financial assets such as stocks, bonds, or currencies. With a commodity future, the underlying goods can be just about anything other than a financial asset. There are commodity futures contracts on a wide variety of agriculture products. Wherever there is price volatility, there may be a demand for a futures contract and new futures contracts are introduced on a fairly regular basis. In contrast, options contract is an agreement that gives the owner the right, but not the obligation, to buy or sell some asset at a specified price for a specified time. Options can be divided into two, puts and calls. The owner of call option has the right but not the obligation, to buy an underlying asset at a fixed price, called the strike price or exercise price, for a specified time. The owner of a put option has the right but not the obligation, to sell an underlying asset at a fixed price for a specified time. The act of buying or selling the underlying asset using the option contract is called exercising the option. Some options can be exercised anytime up to and including the expiration date, other options can be exercised only on the expiration date. Because the buyer of a call option has the right to buy the underlying asset by paying the strike price, the seller of a call option is obligated to deliver the asset and accept the strike price if the option is exercised. Similarly, the buyer of the put option has the right to sell underlying asset and receive the strike price. In this case, the seller of the put option must accept the asset and pay the strike price.

3.0 THE ADVANTAGES AND DISADVANTAGES OF DERIVATIVE MARKET

This market is introduced in intermediaries because to help people in order to protect the value against risk of price of asset owned going in an unfavourable direction. This market can transfer of risk from the people who are not willing to take it as hedgers to the other people who are has their intention to assume it as a speculators. From this change, there are the advantages of derivative market.

3.1 ADVANTAGES

The first advantage of derivative market is enable price discovery. Derivatives market has encourage large number of people with objectives of hedging, speculation, arbitrage to take part in the market and it will increase the competition. So, the large number of people are keep track of prices and trade for a little reason. The individual with more information and better judgement are inclined to participate in the market to take advantage of such situation. When the price is change in small value, it will attract some action on the part of speculators. Active participation in the market in large number of both buyers and sellers will ensures a fair price. So, the increased number of participants will make more trades, more volumes and sensitivity to smallest of price changes facilities correct as well as efficient price discovery of assets. The second advantage of derivative market is provide leveraging. In order to take position in derivatives, the buyers require very small initial outlay of capital so that they can take a position in the spot market. For example, Malik is a buyer and he want involve in derivative market. He believes that the price of rice shall be at price RM30/kg in 2 month from now and that a farmer has agreed to sell it at RM28/kg. So, Malik should take this advantage to buy at full amount RM28/kg today and he will realise RM30/kg in 3 months later. However, there are the other ways that the buyer should not pay at full payment. To make this happen, they should enter into such contract. Derivatives provide those exit routes by letting one enter into a contract and can neutralize their position by booking opposite position on a future date. The third advantage is facilities transfer of risk. When we involve in derivative market, we are a way from the risk because derivative instruments do not involve risk. Instead, derivative instrument redistribute risk between the various market participants. In other word, derivative can be compared with insurance where it provide facilities that cover against over the unfavourable market movements in return for a premium and provides opportunities to those who are willing to take risks and make profits in the process. The fourth advantages of derivative market are lower transaction costs. This is because the number of participants that involve in the market that make this happen. In the derivative market, the high number of participants that take part in the market make the cost become low. The fifth advantage of derivatives market is the market is efficient. This market is said to be efficient or in other word is to be complete market when the available instruments can by itself or jointly cover against something in possible adverse outcomes. However, it is theoretical concept which is not seen in practice. But, there is greater degree of market completeness even with the presence of derivatives market.

3.2 DISADVANTAGES

However, there are disadvantages of derivative market. The first disadvantage is increased need of regulation. The large number of participants that involve in derivatives market. From this involvement, there are exist speculative positions. So, it is necessary to stop these activities which speculative to prevent people from getting bankrupt. Besides that, it also to stop the chain of defaults. The second disadvantage is raises volatility. This is because there will be many speculator when there are the large number of market participants that take part in derivative market. This is due when there involve with small initial capital due to leveraging derivatives provide. When this happen, it will leads to speculation and raises volatility in the market when they are speculate the raise and down of the price in the market. The third disadvantage of derivative market is higher number of bankruptcies. This is happen due to leveraged nature of derivatives. Participants assume positions so that they will buy in large amount. But, some people make a buying which do not match with their financial capabilities. As a result, it eventually leads the participants to bankruptcies.

4.0 OVERVIEW OF DERIVATIVE MARKET IN MALAYSIA

Derivatives are a form of security where it is derived from one or more underlying asset. Derivative is a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and indices. Derivatives are financial instruments that are widely used to manage a participants exposure to fluctuations in the financial markets. Derivative instruments can be traded on a formal exchange or market Counter (Over-The-Counter). Futures and options are the basic products are mostly traded derivatives in formal exchanges such as Bursa Malaysia Derivatives Berhad (BMD). On September 17, 2009, Bursa Malaysia Berhad entered into a strategic partnership with the Chicago Mercantile Exchange (CME) in order to improve access to derivatives offerings globally. This includes licensing for FCPO settlement prices to position Malaysia as a global benchmark for commodity prices and global distribution for Bursa Malaysia through Globex electronic trading platform. CME currently holds 25 per cent equity interest in Bursa Malaysia Derivatives Berhad, while the remaining 75 percent interest held by Bursa Malaysia Berhad. Bursa Malaysia Derivatives Berhad (BMD) was established to meet the growing need for financial risk management in Malaysia. The main role of Bursa Malaysia Derivatives Berhad is to ensure market integrity and to ensure the orderly conduct of trading futures and options. Futures industry in Malaysia is governed by the Futures Industry Act 1993 "FIA". "FIA" is a form of regulation for trading futures and options as well as the Capital Markets and Services Act 2007 (Capital Market Services Act - CMSA). This regulation comes under the jurisdiction of the Securities Commission, which is authorized by the Ministry of Finance. The two organizations together responsibility for setting guidelines for the operation of Bursa Malaysia Derivatives Berhad. The Securities Commission also is the approving authority for all contracts traded in accordance with the provisions of the law and also for the licensing of participants in the market as a Futures Broker's Representative. All customers are required to place a deposit margin with Bursa Malaysia Derivatives Clearing Berhad, as a goodwill deposit before starting trading in the futures market. This deposit is known as initial margin. Typically, trading participants (Trading Participant) it is the futures broker will be a representative to collect deposits from customers and submit it to the Bursa Malaysia Derivatives Clearing Berhad. A The Bursa Malaysia Derivatives Clearing Berhad clears and manages counter party risks in relation to all contracts traded on Bursa Malaysia Derivatives Berhad. It is also regulated under the FIA 1993 and has its own business rules to govern the contractual relationship between itself with each of its Clearing Participants Below is the illustration of the trading and clearing process: Description: https://www.apexequity.com.my/cms/img_ed/overview.jpg Bursa Malaysia Derivatives Clearing Berhad (BMDC) will secure and manage the risk of all parties involved in a trade in respect of all contracts traded on Bursa Malaysia Derivatives Berhad. BMDC also require daily settlement for all transactions, thus providing tight control over margins due to price changing.

5.0 MAIN ISSUE ABOUT DERIVATIVES MARKET

5.1 FIRST ISSUE

Saturday October 20, 2012

BURSA NET PROFIT DOWN SLIGHTLY IN Q3 ON WEAKER SECURITIES TRADING

PETALING JAYA: Bursa Malaysia Bhd's net profit fell 4.1% to RM37.03mil in the third quarter ended Sept 30 from RM38.62mil recorded in the previous corresponding quarter on weaker securities trading. Revenue dipped 1% to RM106.21mil from RM107.31mil with earnings per share declined to 7.0 sen compared with 7.3 sen previously. Chief executive officer Datuk Tajuddin AtanA said: "In the prevailing market conditions, Bursa has attained a stable performance for the first nine months of the year with a marginal growth in PATAMI (profit after tax and minority interest), driven by growth in stable revenue, derivatives business and Islamic market, and coupled with lower operating expenses." For the nine months ended Sept 30, its earnings showed a 0.8% increase to RM115.75mil from RM114.82mil previously. Revenue declined to RM322.68mil from RM324.47mil. "The softer performance was in line with the weak securities trading regionally but cushioned by successful initial public offerings (IPOs) in our market," Tajuddin said in a statement. The results came after its counterpart, the Singapore Exchange, announced that a decline in trading volume dragged down its net profit for the first quarter ended Sept 30. Net profit fell 15% to S$74mil on revenue of S$160mil. Tajuddin said the stock exchange operator was committed to maintaining the level of performance by undertaking various initiatives that would accomplish its business objectives and strategies, notwithstanding the market conditions. Meanwhile, trading revenue of the derivatives market rose to RM40.6mil from RM38.7mil, attributable to the improved performance of total traded volume that rose to 6.95 million contracts against 6.32 million contracts in the first nine months of 2011, driven by the increase in the trading volume of crude palm oil futures. On the Islamic market front, Bursa Suq Al-Sila (BSAS) recorded a 79% rise in its average daily trading value to RM2.06bil for the period under review from RM1.15bil previously. The spike was due to the increasing use of BSAS as a commodityA murabahahA trading platform. https://biz.thestar.com.my/news/story.asp?file=/2012/10/20/business/12201103&sec=business

Summary of the news

From the article above about the issue of derivatives market, we can conclude that the bursa saham suffered a declining net profit by 4.1% because of the weak security trading. The earning per share dropped from 7.3 cent to 7.0 cent. Meanwhile the derivatives market is rise up from RM38.7mil to RM40.6mil. this is because the increase of trading volume of the crude palm oil futures.

5.2 SECOND ISSUE

Bursa Malaysia Derivatives wins award

Published: 2012/09/19 Bursa Malaysia Derivatives (BMD) won the "Best Technology Innovation by an Asian Exchange" award and emerged runner-upA in the "Asian Derivatives Exchange of the Year" award category at the Futures & Options World Award ceremony held in Singapore yesterday.A Factors that contributed to the recognition included, easy accessibility and global connectivity of the Malaysian derivatives market, a statement by Bursa Malaysia Bhd today said.A BMD had implemented several technological enhancements over the last two years, including migration to the Chicago Mercantile Exchange's GLOBEX Trading Platform, and hosting an Order Management System to move domestic futures brokers to a CME-certified broker front-end system.A It also launched a new Derivatives Clearing System with multiple functionalities and capabilities with a SPAN risk-based margining system .A As part of its market development drive, Options on the FKLI was re-launched and a new product, Options on Crude Palm Oil futures contract (OCPO) was subsequently launched in July 2012.A "Derivatives is becoming well accepted as a tradable and hedging product that create opportunities and we see huge potential in this market.A "The partnership with the Chicago Mercantile Exchange (CME) Group has indeed assisted our growth story.A "This award recognition, clearly validates the economic path that Malaysia has taken to globalise the derivatives market," the Chief Executive Officer of Bursa Malaysia and BMD Chairman, Datuk Tajuddin Atan said.A Tajuddin said the strong support from the Ministry of Finance, Securities Commission, Bank Negara Malaysia and Trading Participants have been key to transitioning Malaysia into a regional and global marketplace. Bernama A https://www.btimes.com.my/Current_News/BTIMES/articles/20120919212211/Article/index_html#ixzz2Ce5mBzKX

Summary of the news

The article conclude that Bursa Malaysia Derivatives (BMD) won awards for the achievements in the year 2012. Factors that contributed to the recognition included, easy accessibility and global connectivity of the Malaysian derivatives market. BMD also had implemented several technological enhancements over the last two years, including migration to the Chicago Mercantile Exchange's GLOBEX Trading Platform, and hosting an Order Management System to move domestic futures brokers to a CME-certified broker front-end system.A It also launched a new Derivatives Clearing System with multiple functionalities and capabilities with a SPAN risk-based margining system. CEO of Bursa Malaysia and BMD chairman, Datuk Tajuddin Atan stated that the award has taken Malaysia to the globe of the derivatives market.

6.0 CONTRIBUTION TO MALAYSIA ECONOMY

Economy of a certain country depends basically form the demand and supply. Derivatives market in Malaysia is largely being used in the economy in the world including Malaysia. The markets have many importance towards the economy stabilization and growth. The derivatives market introduced because to help people value against risk of price owned going to unfavourable direction and this means that this will make it secure of people in Malaysia to use the derivatives market as the financial instrument. This will lead to the growth of the economy in Malaysia. The derivatives market play a vital role both financial and non-financial institutions. In Malaysia the increasing of volume of trading derivatives market is the crude palm oil. Over the past nine months the increasing of the volume of crude palm oil make the total traded in the market is the highest. It is also true that growth of derivatives market reveal the increasing market demand for risk managing instrument in the economy. But the major concern is the main components of OTC derivatives are interest rates and currency swaps. Then economy basically will suffer if the derivatives is misused and if a major takes place in derivatives market. The derivatives markets provide facilities for investors who require innovative investment tools and flexible to take advantage of the opportunities of the global market, this will lead to increase number of investors in Malaysia. Offering appropriate above-average returns to investors and portfolio protection, and offers facilities for hedging activities that can produce efficient financing for the investment portfolio will make a big contribution towards the growth of economy in Malaysia. Derivatives Market never failed to contribute to the growth of Malaysia economy because it is nowadays the most growing market in Malaysia.

7.0 CHALLENGES IN THE DERIVATIVES MARKET

Derivatives give an impact on the financial economy as well as the real economy in the country. It is because there is much risk in this market. The price and rate volatility have increased in recent decades. This can cause for concern for a particular firm depends on the nature of the firm's operations and its financing. The price fluctuations have greatest impact on the value of the firm. Sometimes it will be obvious, but sometimes they will not be. The derivatives may result in large losses to the investors because of the use of leverage or borrowing. The investors assume positions which do not match their financial capabilities and they could lose large amounts if the price of the underlying moves against them significantly. It will curtail real economic activity, which can cause a recession. It exposes investor to counter party risk in a financial transaction. Investment losses can occur if the investors lack of research and sound investment because they are not prepared well. The risk transfer factor needs to be applied in a targeted way in order to ensure that the investor does not take unnecessary risks, especially in swaps derivatives. Different types of derivatives have different levels of counter party risk. The derivatives give the challenge to those who are not familiar with speculative markets. It trade directly and only on uncertainty. It becomes relevant for volatility in the financial markets and is not in direct correlation with the fundamental value of the assets that are being traded in the derivatives market. An investor who cannot adapt with uncertainty in investment will tend to take different type of investment structure. Some derivative contracts involve foreign currency that is associated with transactions in the underlying item. The firm must exchange foreign currency for domestic currency to realize the domestic value of its foreign-denominated in a foreign currency. They face a risk of changes in the exchange rate between the foreign and domestic currency as they negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating. The time decay of an options contract can affect the investors because they have to pay a fee for the trade for which is never transacted. But it also can affect the buyer where he will lose that fee which secured the option to buy if he chooses not to complete the transaction. So the challenges that happened in the derivatives market in some ways weakens the basis of asset price. Financial stability as observed with the role of derivatives is effectively based on price changes as derivatives have little relation to the principal asset prices and only work on the price changes for these assets.

8.0 CONCLUSION

The derivatives market gives benefits to the investors and the overall economy of a country. They can create a new business, and any employment opportunities from the profit they gained from the derivatives market. A derivative product's value depends upon and is derived from an underlying instrument, such as commodity prices, exchange rates, interest rates, indices and share prices. It instruments can be traded in an organized exchange or over-the-counter (OTC). The exchange traded transactions are standardized contracts whereas the over the counter transactions are tailored to investors requirements. The derivative gives benefits such as (i) Provide facilities to investors who need an investment tool that is innovative and flexible and can take the opportunities of global markets; (ii) Offers above-average returns and portfolio protection to investors, and (iii) Offer facilities for hedging activities that can produce an efficient financing for the investment portfolio. The derivatives market contains the instruments that are very complex such as futures, and options contracts. The investors need to have a good knowledge and understanding in order to success in trading futures and options. It is because the derivatives work on price changes, or volatility of the asset prices. This market transfer risks from one party to another party.

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