LECTURE 1:

INTRODUCTION TO FUTURES
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Objectives
• Define hedging and outline the advantages and disadvantages of
hedging with futures
• Determine whether a hedger should be buying or selling futures in
order to achieve the desired hedge
• Give reasons why hedging may not provide complete protection
against price risk
• Explain basis risk and identify different types of basis risk
• Justify the importance of speculators and arbitrageurs in the futures
market
• Describe how a trader is able to identify an arbitrage opportunity in
the futures market
• Outline the components of the spot-futures parity theorem
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What are Derivatives

• Derivative instruments are financial instruments that
derive their value from the value of an underlying asset.

• A derivative instrument in itself holds little value, and its

entire value is dependent on the underlying asset.

• Example: Suppose I buy and hold a Crude Palm Oil

(CPO) futures contract. The value of this contract will rise
and fall as the value or price of spot CPO rises or falls.
Should the underlying asset, CPO in this case, rise in
value, then the value of the CPO futures contract that I am
holding will also increase in value.
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Common Derivative Instruments

• Forward Contract
• It is a contract between two parties (over-the-counter)
agreeing to carry out a transaction at a future date but at a
price determined today.

• Futures Contract
• A futures contract is simply a standardized and exchange
traded form of forward contract.

• Similar to forward contract, futures contract represents an

agreement between two parties to carry out a transaction at
a future date but at a price determined at contract initiation.

• The difference is that futures are standardized and

exchange traded.
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Common Derivative Instruments

• Option Contract
• An option contract provides the holder the right but not the
obligation to buy or sell the underlying asset at a
predetermined price.

• Swap Contract
• It is a transaction between two parties which simultaneously
exchange cash-flows based on a notional amount of the
underlying asset.
• The rate at which the amounts are exchanged is
predetermined based on either a fixed amount or an amount to
be based on a reference measure.
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Evolution of Derivatives
• Similar to all other products, derivatives evolved through
innovation in response to growing demands of businesses.
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Evolution of Derivatives
• Chronologically Forward contracts are probably the first
derivative instruments.
• Forward contracts tends to mitigate price risk between two
parties.

• Example: A commodity producer is afraid of fall in prices

when his commodity is ready in future, while a consumer
is fearful of an increase in prices in future. Both parties
meet, negotiate and agree on a price at which the
transaction can be carried out at the future date, thus a
Forward Contract.
• The benefit of this contract is that both parties have
eliminated price risk by locking in their price/cost.
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Evolution of Derivatives
• The forward contract has inherently three limitations
• Multiple Coincidence: Both parties should have opposite
needs with respect to underlying asset, and matching
timing and quantity.
• Unfair Pricing: In forward contract, the price is reached
through negotiation. Stronger bargaining position of one
party may lead to imposition of the price.
• Counterparty Risk: Though it is a legally binding contract,
the recourse is slow and costly. This increases the default
risk in forward contract.

• As these shortcomings of forward contracts became

apparent the Need for Futures Contract developed.
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Evolution of Derivatives
• Futures Contract are essentially a standardized forward
contract traded on an exchange.
• The problems in forwards contracts are addressed via :
• Multiple Coincidence is resolved via exchange trading.
Buyers and Sellers would transact in the futures contract
maturity closest to needed maturity and in as many
contracts as needed to fit the underlying asset size.

• Unfair pricing is resolved since each party is a price taker

on the exchange with the futures price being that which
prevails in the market at the time of contract initiation.
• Counterparty risk is overcome via the exchange acting as
the intermediary guarantees each trade by being the
buyer to each seller and seller to each buyer
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Evolution of Derivatives
• Futures while overcoming flaws of forwards were inadequate
for later day business needs.
• Futures enabled hedging against unfavourable price movement,
BUT being locked-in also meant that one could not benefit from
subsequent favorable price movements.

• This precise inadequacy is addressed by Option Contracts. It

has three marked benefits over its predecessors:
• Options provide cover against both upward and downward
movement of asset prices.
• They are extremely flexible and can be combined to achieve
different objectives/cash flows.
• Complicated business situations cannot be handled by futures
and forwards, but by Options only.
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Main Players in Derivative Market

• Hedgers
• Hedgers are players whose objective is risk reduction.

• Hedgers use derivative markets to manage or reduce risks.

• They are usually businesses who want to offset exposures

resulting from their business activities.

• Speculators
• They are players who establish positions based on their
expectations of the futures…….
• They take positions in assets or markets without taking
offsetting positions, expecting market to perform according to
their expectation.
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Main Players in Derivative Market

• Arbitrageurs
• Arbitrageurs are players whose objective is to profit from pricing
differentials mispricing.

• Arbitrageurs closely follow quoted prices of the same

asset/instruments in different markets looking for price
divergences. Should the divergence in prices be enough to make
profits, they would buy in the market with the lower price and sell
in the market where the quoted price is higher.

• Arbitrageurs also arbitrage between different product markets.

For example, between the spot and futures markets or between
futures and option markets or even between all three markets.
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Commodity v/s Financial Derivatives

• Commodity Derivatives
• Commodity derivatives have tangible underlying assets
like agricultural product and metals.
• All commodity derivatives have actual and physical
settlement of underlying commodity at maturity.

• Financial Derivatives
• Financial derivatives have financial instruments as
underlying assets.
• Unlike commodity derivatives, financial derivatives are
cash-settled at maturity.
• Cash settlement involves not the exchange of actual
underlying asset but the monetary equivalent of the asset.
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Trading Methods
• There are two trading methods for derivative exchanges.

• Open Outcry Method

• In an open-outcry system, trading is done in a trading hall by
means of shouting out orders and by the use of hand signals.

• Computerized/Screen Based Trading

• Trading is done by means of a distributed computer system.
• Buy and sell orders are entered directly into dedicated
terminals at futures broker offices.
• The futures brokers are connected to a mainframe computer
which acts as the matchmaker.
• Matchmaking is done via highest bid and lowest offer matching.
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Clearing House
• A clearinghouse plays two key roles:
• Record keeping
• When a customer does a trade the broker has to clear the trade
with clearinghouse via a clearing member.
• The clearing house records and registers every single trade.
• This allows it to carry out second function.
• Risk management: It has to manage risks at two levels:
• Firstly it acts as intermediary to all parties to mitigate
counterparty risk. This mitigation of counterparty risk is a key
facility in enhancing trade.
• Secondly by implementing margin requirements to ensure no
party defaults.
• Bursa Malaysia Derivatives Clearing BHD (BMDCB) is the sole
clearinghouse for both financial and commodity derivative
transactions.
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Futures Contracts
• Futures contracts were introduced to address the problems
in Forward contracts.

• Futures contracts are standardized and exchange traded

forward contracts.

• Standardization enables futures contracts to be traded on

exchanges. Key features that are standardized:
• Maturity, Quantity, Quality and Place of delivery
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Futures Contracts
• Key features of futures contracts in comparison with
forward contracts are:
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Futures on what? Contract Specifications

• Agricultural futures
• Metals futures
• Foreign currency futures
• Energy futures
• Stock index futures
• Interest rate futures
• Bond futures
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Requirements for a Viable Futures Market

• A deep market is needed – number of buyers and sellers
have to remain large enough to provide continuous
opportunity for trade
• The commodity selected for trading has to be easily
graded
• To ensure the grading of commodities did not change,
regular government inspections have to be carried out
• Payment has to be met at the time of delivery
• To minimise the risk of default, buyers and sellers have to
establish financial responsibility
• Prices have to be reported publicly
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Issues in Future Trading

• Leverage and Transaction Costs
• Leverage is the ability to make large profits (or losses) for
….

• Futures contracts and derivatives in general have lower

transaction costs.
• Example: In Malaysia, transaction cost of using Stock Market
and Index futures is substantially lower, the than spot market.
• Derivatives have inbuilt leverage.
• Futures contracts have inbuilt leverage since one need only
pay the initial margin and not the full amount.
• Example: In our example, the confectioner was required to pay
only 10% of the price, RM 1.200 instead of the full price.
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Issues in Future Trading

• Long – buy a futures contract and receive delivery in future

• Short – sell futures contract and make delivery in future

• Basis – difference, or spread, between the cash price (or

spot price) of the instrument and the futures contract.
• Position limit – limit the total number of positions that may be
held by a single account to avoid disruption
• Price limit – limits on the range within which prices of futures
can fluctuate during 1 day’s trading session
• Contango – futures prices higher than cash prices

• Backwardation – futures prices lower than cash prices

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Mechanics of Future Trading

• To understand the mechanism of Future trading we would
carry on with the earlier cocoa farmer and confectioner
example.
• Assume Farmer expects to produce 120 tons of cocoa in
6 months time.
• The futures contracts are available in 3, 6, 9 and 12
months maturity with a standard size of 10 ton per
contract.
• The current quoted price for 6 month cocoa future is RM
100 per ton, translating into RM1,000 per contract.
• For simplicity purposes, assume confectioner also
requires 120 tons of cocoa in 6 months time.
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Mechanics of Future Trading

• The hedging mechanism would operate as follows.
• The cocoa farmer would call his broker and sell(short) 12
contracts of 6 month cocoa futures.
• The farmer now knows he will receive RM 12,000 (RM 1,000 x
12) in 6 months.
• The confectioner will call his broker and buy (long) 12 contracts
of 6 month cocoa futures.
• The confectioner now knows he has to pay RM 12,000 (RM
1,000 x 12) in 6 months.
• Neither parties need to know who the counterparty is and are
assured of the delivery/payment of the trade.
• On registration of the trade, the clearinghouse guarantees the
performance of the contract.
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Main Players in Futures Market

• Hedgers
• Hedgers use futures contracts to manage their price risk.
• They are typically businesses that use derivatives to offset
exposures resulting from their business activities.
• Example: In our continuing example, once the cocoa farmer has
planted cocoa, he is “long” in cocoa, since he is committed to
produce it. He is now exposed to price risk. To offset that risk he
takes a “short” position in cocoa futures.
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Main Players in Futures Market

• Hedgers
• Hedgers use futures contracts to manage their price risk.
• They are typically businesses that use derivatives to offset
exposures resulting from their business activities.
• Example: In our continuing example, the confectioner needs
cocoa in six months time, so he is “short” in cocoa. To offset
that risk he takes a “long” position in cocoa futures.
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Main Players in Futures Market

• Hedgers
• There are two equivalent ways to determine the appropriate hedge
position.
• View from the underlying asset position: This is if you are long the underlying
asset, then the position in a futures contract of the same underlying asset should
be short and vice versa.
• View from price risk : To protect yourself from rising prices of the underlying
asset, long the futures contract. To protect against falling prices, short the
futures contract.
• One who would be long in an asset now, would be afraid of falling asset prices
and would go short to hedge and vice versa.
• An Anticipatory hedge is when a producer anticipates having a position
in the underlying asset at a future point and want to hedge against it.
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Main Players in Futures Market

• Arbitrageurs
• Arbitrageurs, use derivatives to engage in arbitrage.
• Arbitrage is the process of trying to take advantage of price
differentials across different markets
• Arbitrageurs closely follow quoted prices of the same
asset/instruments in different markets looking for price
divergences. Should the divergence in prices be enough to
make profits, they would buy in the market with the lower price
and sell in the market where the quoted price is higher.
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