LO1: Able to explain the basic concept of derivatives and its environment.(30 marks)
Question 1: Explain the forward contract with appropriate illustration. (6 marks)
Forward contract is a customized contract where two parties agree to buy and sell an asset at a predetermined price while the settlement and delivery will be executed in the future. It is an over-the-counter derivative contract with customized terms which allows the oil refiners to fix the price they purchase the crude palm oil (CPO) from the oil palm estate. (Investopedia, 2016) As mentioned earlier, a forward contract is an obligation where both parties agree simultaneously that they will take on full responsibility to oblige the contract on specific date in the future. If any parties failed to oblige the contract, the counterparty will be at risk for the transaction. (Wikipedia, 2016) Two parties may enter into a forward contract when they have different future expectations. For instance, the oil palm estate owner may expect that the price of CPO will be falling in the near future, while the oil refiner expects the price of CPO will be hiking in the near future. Both of these parties can be introduced to use a forward contract to fix the price for the transaction today and will be settled in the future. For example, the oil palm estate agreed to sell 250 metric tons of CPO at the price of RM28,000 to oil refiner where the cash settlement and delivery will be at 3 months later. Whereas the cash settlement of RM28,000 will be executed by the oil refiner in the time of exchange of 250 metric tons of CPO by the oil palm estate. The main objective of utilizing forward contract is to lock in the price today; thus, there are no any direct losses will be incurred in the transaction if the future price movements are favorable to both parties. In contrast, indirect losses would be incurred if the future price movements do not favorable to both parties as what they expect at the beginning.
Illustration 1: Forward Contract
3 months later
Question 2: Explain the futures contract with appropriate illustration. (6 marks)
Futures contract is an agreement between two parties to buy or sell a specific commodity or financial instrument at a predetermined price and specific date in the future. Futures contract has the similar features as forward contract at general except futures contract is traded in an organized exchange. The future exchange has a clearing house where the buying and selling price of the underlying assets will be quoted accordingly. Parties that involved in futures contract are required to maintain a certain margin in their account because the futures contract is marked-to-market in daily basis. In other words, the profit and loss of both parties will be recorded every time according to the settlement price of the day. Hence, the profits and losses will be reflected in the margin of their accounts. On occasion of margin deficiency, the party is required to receive margin call in order to fuel more margins to their account. Hence, the major difference between forward contract and futures contract is the absence of counterparty risk in futures contract. In a futures contract, the quantity of the underlying assets and the delivery period are standardized. The delivery period is usually on short term basis such as one month, two months, three months or six months. For instance, both parties enter into a futures contract, if the oil refiner expects the CPO price to rise, while oil palm estate owner expect the price of CPO will drop in near future. The oil refiner agrees to long 3-month CPO futures at RM2,500 per metric ton from the clearing house while oil palm estate agrees to sell 3-month crude palm oil futures to the clearing house at the same price. The settlement will be executed by oil refiner through clearing house to oil palm estate when the contract expires. However, there are two types of settlements under futures contract. There are two types of delivery settlement which depending on contract terms are physical delivery and cash settlement. Cash settlement carries the implication that no physical CPO delivery will be done whereas accumulated gain or loss of futures contract will proceed to clearing house. Another alternative way of settlement will be physical delivery which means the CPO will be delivered from the oil palm estate to the oil refiner. Assuming that CPO futures price increases to RM2,800 per metric ton from RM2,500 per metric ton, if the contract is based on cash settlement, then the account of oil refiner will be credited with RM300 as a gain at the end of the contract. Meanwhile, if the contract is based on physically settlement, then the oil palm estate will deliver CPO physically to oil refiner and the oil refiner will be able to lock in at cheaper price and benefited from the long position.
Illustration 2: Futures Contract
Question 3 : Differentiate forward contract and futures contract [6 marks]
Forward contracts are very similar to future contracts however there are few ways to differentiate between these two financial instruments. Future contracts are standardized contracts, which traded in exchange. On the other hand, forward contracts are customized contract between two parties which traded on an over-the-counter. (Options Guide, 2016) In other words, the customized terms in a viable forward contract must be mutually accepted by both of the involved parties to have the contract enforceable, while future contracts are standardized and cannot be customized. There is a formal and standardized format for future contracts in the derivatives market. Hence, the type of commodity, delivery time, settlement price can be negotiated and pre-determined by the two parties in a forward contract. However, the contract has no guarantee over the both parties; the counterparty risk may arise on occasion of default by one of the parties. Nevertheless, the future contract has zero counterparty risk with the existence of clearing house. For forward contract, the only guarantee exists in the contract is merely the trust and bond between the involved parties. Lastly, initial margin payment and margin maintenance is necessary in future contracts while these do not exist in the forward contracts. Future contract holders will receive margin call to replenish the margin up to minimum level upon depletion or deficiency of margin in the accounts.
Table 1 : Difference between Future Contract and Forward Contract
Contract Type Future Contract Forward Contract
Contract details Standardized Customized
Trade on Future Exchange Over-The-Counter
Counterparty risk No counterparty risk Counterparty risk
Initial payment Initial margin payment required No initial payment required
Transaction method Quoted and traded on future exchange Negotiable
Guarantee Clearing house Contract parties
Question 4 : Discuss the main players in the derivatives market and their objective. [12 Marks]
There are 3 main players in the derivatives market, which are hedgers, speculators and arbitrageurs.
Hedgers are generally more inclined to be risk adverse. Their main objective in derivatives market is to seek for ways to limit or control the losses they might face when there is adverse movement in the price of some underlying assets. (Slideshare, 2016) For instance, oil palm estate that produces CPO will gain extra profit in the future if the price of CPO goes up. However, they might face a tremendous loss if the CPO price moves unfavorably. Hence, they come into the derivatives market as a hedger that seeks to use derivative instruments to limit the losses or lock-in the price for future transaction. By using forward contract, the oil palm estate owner agreed to sell 250 metric tons of CPO to the oil refiner at the price of RM28,000. At this rate, the price that they used in the above transaction is predetermined. Hence, hedgers will able to limit the losses with the same amount regardless of the price movement in the future
The second type of main players in the market is speculators. Speculators are willing to take risk to participate in derivatives market and hoping for a chance to make profit. These kinds of players generally speculate on the price movement of various instruments in the market base on their forecast and expectations on future economic condition. (Binary Tribune, 2016) Hence, most of the speculators are gathered in the futures contract market due to the existence of secondary market and nature of high liquidity. Apart from that, futures market allows speculators to perform either long or short position to make profit from both upside or downside of future price movements in the underlying assets. (Binary Tribune, 2016) On occasion of any mistakes, they can quickly switch their position to benefit from the running trend with the aid of high liquidity of futures market. For example, if the oil refiner expected the future price of CPO will be surging up, then the oil refiner can long the CPO future contract to increase his profit margin from the rally instead of taking in a short position. However, it’s quite clear cut to say being speculative is very risky if the futures price of CPO move unfavorably to the producer.
Arbitrageurs are a group of intelligent investor, who seek to invest capital and intended to make riskless profit from mispricing in various markets. It generally involves one or two mispriced goods or instruments. For instances, if the spot price of CPO is RM2,829.50, 3-month risk free rate of Malaysia Treasury Bill is 3.18% per annum and 3-month future price is RM2,860 as opposed to RM2,851, an arbitrageur can long the CPO for RM2.829.50 and short the futures contract for RM2,860. Assuming no storage cost, when the commodity is deliver for RM2,860, the arbitrageur will earns RM9 in excess that earned investing in the risk free asset.
O2 : Able to price the commodity futures contract.
Question 1
Determine the fair price of a CPO futures contract that you have chosen and explain the factors that might affect the pricing of CPO.(10 marks)
According to our research for the CPO futures contract, the fair price of futures contract was determined as the following;
Ft,T =S0(1 + rf + c – y) t,T
=RM2,829.50(1+0.0311+0.010603-0) 3/12
=RM2,858.55
Where;
Ft,T = futures price for a contract with maturity from t to T (t = today, T = maturity)
So = current spot price of the underlying asset
rf = annualized risk free interest rate
c = annualized storage cost in percent
y = convenience yield
There are numerous of factors would affect the pricing of CPO in the market. By knowing the factors that affect crude palm oil prices (CPO) is crucial especially for market participants who actively trade Crude Palm Oil Futures (FCPO).
Spot price would be one of the main factors that affect the pricing of CPO while the spot price is referring to the current market price at which the CPO will be traded in the spot market. Spot price will be affected by the demand and supply of the CPO which traded in the spot market. Any crisis that arises such as global economic downturn, importers of CPO like China, India and Europe will decrease the consumption of CPO and lead to a decrease on demand of CPO. It would also push down the price of CPO and lead to surplus of supply of exporters such as Malaysia and Indonesia. (Oriental Pacific Futures, 2016) If the demand of CPO is relatively high compare with the supply of CPO, then the spot price would be higher, vice versa. The higher price of spot price would affect the future price to be higher. In other words, spot price and futures price are highly correlated. According to the Malaysia Palm Oil Board (MPOB), the spot price of CPO on 8th November 2016 is RM2829.50 per metric tons as shown in Appendix B.
Apart from that, short-term risk free rate would able to affect the pricing of CPO futures contract. If the future price differs from the spot price compounded at the short-term risk free rate, then arbitrage opportunities would exists in this situation. (Investopedia , 2016) For case in point, if the spot price of CPO is RM2,829.50, by looking at Appendix A, 3-month risk free rate of Malaysia Treasury Bill is 3.11% per annum and 3-month future price is RM2,860 as opposed to RM2,851, an arbitrageur can long the CPO for RM2.829.50 and short the futures contract for RM2,860. Assuming no storage cost, when the commodity is deliver for RM2,860, the arbitrageur will earns RM9 in excess that earned investing in the risk free asset.
In spite of that, commodities like CPO typically incur a storage cost which would affect the pricing of CPO future contracts. From the buyer of futures contract would able to gain by accessing to the CPO in the future without buying it now and incurring storage costs. Subsequently, the amount for storage costs of the CPO will be included in the future price over the life of the contract. Moreover, the storage cost and interest costs together are sometimes mentioned to as “the cost of carry”. Some of the storage costs consist of the handling, spoilage, storage space, insurance cost and maintenance cost. According to the Bursa Malaysia as shown in the Appendix D, the storage costs of CPO futures (FCPO) are RM30 per metric ton. If the oil refiner is a buyer of futures contract, then the storage costs would be 1.0603% per annum.
Storage costs=(RM30 per metric tons )/(RM2829.50)
=1.0603%
On the contrary, the convenience yield given to buyer of CPO futures contract of having physical possession of the commodity and having it promptly available for use. In other words, convenience yield is a non-monetary benefit offered by CPO when in short supply. (Spoiwo, 2016) Hence, the price of the CPO tends to be high when the CPO is in short supply. As mentioned in the formula, the futures price of the CPO is adjusted for the loss of convenience yield. In our studies, we assumed the convenience approximately to be zero as convenience yield is derivable when there is comparable future price. (Andrew Smith, 2000) When there is no comparable futures price, the convenience yield is difficult to estimate as the value may vary over time and across user. (CFA Institute, 2015) When futures price are higher than the spot prices, the commodity forward curve is upward sloping and the prices are referred as contango. Hence, in our studies, the futures price of RM2858.55 is known as contango as it occurs when there are little or no convenience yield exists. When the futures price is lower than the spot price, the commodity forward curve is downward sloping. In this situation, the price is known as backwardation which would occur when the convenience yield is relatively high. (CFA Institute, 2016)
LO3
Question 1
A refiner has 500 metric tons of CPO in inventory. He will be holding this over the next 3 months. He intends to protect himself from a fall in the price of CPO which could cause him losses since his output price is tied to CPO prices. He has the following information.
a) Explain how can the refiner use the CPO futures contract to protect himself from price fluctuation (price risk) (20 marks)
The underlying objective of current study is to determine how a refiner can reduce unfavorable price fluctuation by using an appropriate hedging strategy. In terms of hedging, it works effectively because the futures price and spot price are highly correlated. In order to determine the appropriate hedging position, there are two prognosis must be well determined. First prognosis from the underlying asset position, if the refiner are long the underlying asset, then the refiner must entered into the futures market by doing short hedge strategy and vice versa. In order to protect refiner from price fluctuation, the expectation of the price changes must be clearly identified. If the prices of the CPO rise, then the refiner must long the futures contract. If the prices of the CPO fall, then the refiner must short the futures contract. In a nutshell, if the refiner would be long an underlying asset now, he will implement short hedge strategy from mitigating the risk of price falling in the future and vice versa.
The spot price of CPO is gathered from the Malaysia Palm Oil Board (MPOB) Update report as shown in Appendix B stated at the rate of RM2829.50 on 8th November 2016. (Malaysia Palm Oil Board, 2016) The 3-month future price on 8th November 2016 which stated in Bursa Malaysia and MPOC as shown in Appendix C is RM2843.
According to the contract code which standardized by Bursa Malaysia, a single contract size is equivalent to 25 metric tons of CPO. Since the refiner has 500 metric tons of CPO on hand, which are equivalent to 20 CPO futures (FCPO) contracts.
Number of contracts: 500 metric tons / 25 metric tons = 20 contracts
In the following are the scenarios in the changes of CPO spot prices.
Scenario 1: If the CPO spot prices fell by 6% to RM2659.73 on delivery date.
Action Position today Position on Maturity Profit/Loss
Short 20 future contracts @ RM2843 RM56,860,00 (RM53,194.60) RM3665.40
Long underlying @ RM2829.50 (RM56,590.00) RM53,194.60 (RM3,395.40)
Net gain RM270.00
With the decrease in CPO price to RM2659.73 for every 25 metric ton on the maturity date, the refiner have to pay RM53,194.60 for 500 metric ton. Nonetheless, the decrease in purchase price will be offset by the realized gains in the future market.
The CPO futures price will have converged with the spot price which will be equal to RM2659.73 for every 25 metric ton. As long as the short future position was entered at a higher price of RM2843 per 25 metric ton, the realized gain in this short future position is RM3665.40 for 20 contracts.
In conclusion, the losses of RM3395.40 from the purchasing 20 CPO contracts at the spot price which would be offset by the gain in the futures market. Hence, the net gain by offsetting each other would be RM270. Thus, short hedge is the best strategy for a refiner to mitigate the price fluctuation if the expected spot price will fall in the 3 months.
Scenario 2: If the CPO spot prices rose by 5% to RM2970.98 on delivery date.
Action Position today Position on Maturity Profit/Loss
Long 20 future contracts@ RM2843 (RM56,860.00) RM59,419.50 RM2559.50
Short underlying @ RM2829.50 RM56,590.00 (RM59,419.50) (RM2,829.50)
Net gain RM270.00
With the increase in CPO price to RM2970.98 for every 25 metric ton, the refiner have to pay RM59,419.50 for 500 metric tons. Nonetheless, the increased in purchase price will be offset by the realized gains in the future market.
The CPO futures price will have converged with the spot price which will be equal to RM2970.98 for every 25 metric ton. As long as the long future position was entered at a lower price of RM2843 per 25 metric ton, the realized gain in this long future position is RM2559.50 for 20 contracts.
In conclusion, the losses from the selling at 20 contracts at RM59,419.50 is RM2829.50 which would be offset by the gain in the futures market. Hence, the net gain by offsetting each other would be RM270. Thus, long hedge is the best strategy for a refiner to mitigate the price fluctuation if the expected spot price will rise in the 3 months.
Question 2
Suppose that the recent Malaysian Government Budget indicates the removal of government subsidies for the palm oil producer will cause the cooking oil increase by 10%.
Suppose on a certain day, you notice the following quotes:
CPO spot price Refer to reliable website
rf rate 3% per year
Annual storage cost RM48
3- month CPO futures Refer to Bursa Malaysia
a) Justify whether arbitrage is possible. If so, explain how you could arbitrage from the trade. (20 marks)
F_(t,T)=〖S_0 (1+rf+c-y)〗^(t,T)
=RM 2,829.50(1+ 0.03 + 0.017)1/4
=RM2,862.17
Where;
C, storage cost = (Annual storage cost)/(Spot Price)
=RM48/(RM2,829.50)
=1.17%
In economics and finance, arbitrage opportunity is presents when the arbitrageurs take benefits of the mispricing between two or more markets. (Wikipedia, 2016)It is a practice that purchase and sale of an asset instantaneously to make profit by exploiting the price differences of identical assets on different markets. (The Economic Times, 2016). Arbitrageurs tend to earn riskless profit by generating positive cash flow after transaction costs. Since the underlying asset is the same, a given pricing relationship should hold between the spot and futures. Once this pricing relationship is violated, riskless arbitrage is possible.
From the calculation above, the calculated 3-months CPO futures price is RM2,862.17 but the quoted 3-months CPO futures price which stated in MPOC is RM2,843, therefore the arbitrage is possible in this situation. Furthermore, we will show the calculation about how to perform arbitrage from the trade on the below part.
If future overpriced relative to spot, then the futures is overpriced relative to spot or equivalently, the quoted futures price is higher than what it should be. Method: Short the futures contract, and long the spot market.
If future underpriced relative to spot, then the futures is underpriced relative to spot or the quoted futures price is lower than what it should be.
Method: Long the futures contract, and short the spot market.
Since 2862.17(Calculated Future price)>2843(Quoted future price), therefore we use reverse cash and carry arbitrage method which is long the futures contract, and short the CPO in the spot market.
3-month CPO price = RM 2843
CPO Spot price = RM 2829.50
rf rate = 3%
Time to maturity = 90 days
Scenario 1: If the CPO spot prices rose by 5% to RM2970.98 on delivery date.
Action Position today Position on Maturity Profit/Loss
Long 20 future contracts @ RM2843 (RM56,860.00) RM59,419.60 RM2,559.60
Short spot @ RM2829.50 RM56,590 (RM59,419.60) (RM 2,829.60)
Borrow RM56,590 @ 3% for 90 days (RM56,590) RM57,008.61 RM418.61
Net Gain RM148.61
Scenario 2: If the CPO spot prices fell by 6% to RM2659.73 on delivery date.
Action Position today Position on Maturity Profit/Loss
Long 20 future contracts @ RM2843 (RM56,860.00) RM53,194.60 (RM3665.40)
Short spot @ RM2829.50 RM56,590.00 (RM53,194.60) RM3,395.40
Borrow RM56,590 @ 3% for 90 days (RM56,590.00) RM57,008.61 RM418.61
Net Gain RM148.61
Question 3
Suppose a trader with no current position in CPO spot and futures prices over the next three months. He believes that the removal of government subsidies will cause the reduction in production which will takes effects in the three months. Thus, CPO prices will be headed higher and wishes to profit from his expectation. He then looks for the 3-month CPO futures with 90 day maturity quoted on Bursa Malaysia.
Explain how the trader could speculate the market and the consequences from a rising and falling CPO price scenario. (20 marks)
A successful speculator is a trader who enters the market to make a gain by predicting the short term market condition. For case in point, if the prognosis of a speculator for the price of the CPO futures is going on a downtrend, short selling would be the best strategy for a speculator to act with. Herewith, he will close his position while the futures price of the contract to decline by repurchase the contract and make profits. Apart from that, speculators are intended to seek profit based on their opinion towards the movement of futures price. Thus, speculators are facing higher risks compares with other market participants such as hedgers and arbitrageurs as their anticipation would result in a bigger profit or unlimited losses.
In fact, there are three types of speculators in the market who preferably rely on their own opinion and strategy. First and foremost, scalpers are the one of the speculators who participated in the market which rarely hold position overnight of buying and selling contracts at the slightest move of the price whereby they trading actively to secure profits through small movement of price fluctuations. By trading frequently, scalpers would be able to provide liquidity to the market.
On top of that, day traders participate in the market to hold the positions in order to reap the profits during a single trading day. Mostly, day traders do not hold the position in the futures market overnight but they would hold a longer term compare with scalpers. The main objective for day traders to close their position by end of the trading day is to reduce their risk. There would be higher risks if day traders hold the position overnight as most of the commodities is driven by weather, prices of other commodities and stockpiles.
Last but not least, a position trader is another type of speculator that holds over a period of days, weeks or months. Usually position trader would close their position when the price has moved favorably to them. There are two types of position traders in the market such as outright position and spread position.
In our studies, outright position traders are most appropriate as we are looking at 3-months futures contract which required holding the position for at most three months. Outright position traders are one of the speculators that wisely utilize the commodities futures markets as an easy mechanism to speculate on the price of underlying commodities as it need not the requirement of any holding physical commodities to trade. This can be illustrate as, outright position traders expect the price of the crude palm oil would be at an uptrend in the near future, then they can seek to gain profits by long the futures contracts today and close the position when the futures price hit the targeted price. However, if the price trend goes another way round, the trade would results losses instead of gains.
In our studies, the trader believes that the removal of government subsidies will cause the reduction in production. In this means, in reducing the production would lead to a short supply in physical CPO and hence the price of CPO will be headed higher. By looking at the 3-months CPO futures price on 8th November at RM2,843 as shown in Appendix C, he expects the CPO prices will be in a uptrend and reap a profit by closing the position on February.
Assuming the traders would like to own 500 metric tons in the futures market. Therefore, he should long or short 20 contracts in the futures market according the price trend as the following;
Scenario 1: If the CPO price rose by 5% to RM2,985
Strategy A: Long 20 contracts of 3-months CPO Futures (FCPO) at RM 2,843 and short 20 contracts of 3-months CPO Futures (FCPO) at RM2,985.
Net profit: (Selling Price – Buying Price) x 20 contracts
= (RM 2,985 – RM 2,843) x 20 contracts
= RM 2,840
Scenario 2: If the CPO price fell by 5% to RM2,701
Strategy A: Long 20 contracts of 3-months CPO Futures (FCPO) at RM 2,843 and short 20 contracts of 3-months CPO Futures (FCPO) at RM2,701.
Net losses: (Selling Price – Buying Price) x 20 contracts
= (RM 2,701 – RM 2,843) x 20 contracts
= (RM 2,840)
Thus, if the CPO prices rose to RM2,985 which favorably to the trader, then he would able to make RM2,840. In other words, if the CPO prices fell to RM2,701 which unfavorably to the trader, he would make losses at RM2,840.