Tutorial 1 Q&A

Topic 1

1. What is a derivative instrument? How is it different from stocks and bonds?

Answer:
A derivative instrument is a financial asset that derives its value from its underlying asset.
The underlying asset could be a commodity or another financial asset. Thus, unlike stocks
and bonds that represent a direct claim, derivatives can be thought of as claim on a claim.

P/L Long Hedge P/L Cocoa Farmer

que
+ +
+20 +20

0 Price 0 Price
100 80 80 100

20 20

Confection Short Hedge

Position (Short)

Long Hedge Contract to buy X tons of cocoa at $100 per ton for delivery at a future date
Short Hedge Contract to sell X tons of cocoa at $100 per ton for delivery at a future date

2. The evolution of derivative instruments means that each new derivative is an improvement
on its predecessor. State the operational advantages(s) of (i) futures over forwards, and (ii)
options over futures/ forwards.

Answer:
Futures overcome that 3 problems of forwards:
(i) multiple coincidence of needs,
(ii) potential for price squeeze, and
(iii) counterparty / default risk;
whereas forwards / futures locked-in the underlying asset value, options had the
advantage that they provided both downside protection and upside profit potential.

3. What are the key categories of players in derivative markets? Briefly describe the objective
of each category of players.

Answer:
Hedgers, arbitrageurs and speculators.

Hedgers: to manage risk;

Arbitrageurs: to take advantage of mispricing; and
Speculators: to take positions based on their expectations.

1
 4. How might the absence of speculators/ speculation hurt hedgers?

Answer:
(i) Reduced liquidity, reduced trading volume and so higher transaction cost.
(ii) Lack of counterparties for hedgers to pass on their risk.

5. Differentiate between commodity and financial derivatives.

Answer:
Commodity derivatives have underlying assets that are commodities / tangible assets and have
physical settlement at maturity. Financial derivatives have financial assets as their underlying and
have cash settlement at maturity.

6. Outline some of the key types of risks and identify the appropriate derivative instruments to
manage the risk.

Answer:
(i) market/price risk: derivatives based on the appropriate underlying asset.
(ii) Interest rate risk: use 3 month KLIBOR futures contracts.
(iii) Currency/ exchange rate risk: use currency forward contracts. Since there are no
exchange traded currency in Malaysia, Forwards would be the most logical choice.

* KLIBOR Kuala Lumpur Interbank Offer Rate

7. Differentiate between exchange traded and OTC instruments. Under what circumstances
might one prefer an OTC instrument to an exchange traded one?

Answer:
OTC instruments are customized over the counter instruments whereas exchange traded
instruments are standardized and traded on a centralized exchange.

8. Define what is meant by basis. State three situations that could result in non-zero basis at
maturity.

Answer:
Basis refers to the difference or spread between forward/futures and spot prices. By
definition, basis should be zero at maturity unless there are mismatches. Mismatches could
arise from (i) asset mismatch, (ii) maturity mismatch, and (iii) quantity mismatch.

9. A corporate treasurer who was long 3 month futures contracts on British pound sterling for
400,000 pounds subsequently goes short 3 month pound forward contracts for 400,000
pounds. Assume the exchange rate in both cases is equal. What is his net position in British
pound?

Answer:
2
 Net position is zero.

10. Explain the concept of leverage in the futures market.

Answer:
Leverage is the ability to make large profits (or losses) for relatively small outlays of
capital. In the futures market, leverage is made possible because of the system of margins
whereby for a small initial outlay, a trader has exposure to a much larger sum and can make
huge profits (or losses) from small variations in price.

11. If the cash price for gold is US$400 per ounce, storage for one year is US$7 per ounce and
the risk free interest rate is 5% p.a., what is the fair value price of a gold futures contract
that expires six months from now? Show workings.

Answer:

F = S (1 + r + c y) t
F = 400 (1 + 0.05 + (7/400))1/2
F = 413.28

*c = storage costs per $

12. What is the importance of the speculator in the futures market?

Answer:
The trader/speculator provides trading volume and liquidity and willingly takes on the risks
hedgers try to avoid, in the hope of great profits (for the trader/speculator).

13. Explain the meaning of the terms contango and backwardation in the context of the
futures market.

Answer:
Contango refers to the market situation in which futures prices are trading at a level higher
than cash prices. Backwardation is the opposite situation futures prices are lower than
cash prices.