Futures contract

In layman’s terms, a futures contract is a derivative that derives its value from the value of one or more underlying variables or assets in a contractual manner. The underlying instruments can be equity, financial or commodity assets. For each futures contract, there must be a buyer and a seller. The buyer of a futures contract is said to have taken the long position while the seller of a futures contract is said to have taken a short position. When two parties enter into a futures contract, the contract holders are legally obligated to carry out the contractual transaction at a specific date in the future involving a specific quantity and type of asset at a predetermined price, as stated in the contract.

 

Futures contracts are traded at the exchange, which has a clearing house to ensure that traders in the futures market will honour their obligations. The contracts are highly standardised, usually specifying the underlying instrument, quality, quantity of goods that need to be delivered, the contract size, time of delivery and manner of delivery. An open interest[1] is the number of contracts that are currently in existence.

 

Futures contract holders can choose to close a futures position in three different ways:

 

• Before contract expiration, the contract holders can choose to conduct a reverse or offsetting trade as the other side of the position is held by a clearing house. If the holder makes an exact opposite trade to his current position, the clearing house will remove his positions, leaving him with zero balance.
• Alternatively, holders can hold the contract until expiration. The purchaser of the contract will receive delivery of the goods and pay for it while the seller of the contract will deliver the goods and receive the payment.
• The holders can also find a trader with an opposite position and then deliver the goods and settle among themselves off the floor of the exchange. Exchange for something physical is different from a delivery process because the transaction is negotiated and settled off the exchange.

Futures trading in Malaysia

In Malaysia, futures trading is offered by Bursa Malaysia Derivatives Berhad. There are four types of futures being traded on this exchange:

• Commodity futures. The commodity futures that are active in the market are the MYR denominated Crude Palm Oil Futures (FCPO) and Crude Palm Kernel Oil Futures (FPKO). The USD denominated Crude Palm Oil Futures (FUPO) was newly introduced in 2008 to complement the existing FCPO futures. The underlying asset for both FCPO and FUPO is Crude Palm Oil where as the underlying asset for FPKO is Crude Palm Kernel Oil. Crude palm oil is sourced from oil palm while the crude palm kernel oil is the expeller pressed from the kernels or endosperms of the oil palm fruits.

 

Both FCPO and FPKO are physical-settled contracts, which mean that upon expiry of the contracts, the buyer would have to take delivery of the physical crude palm oil or crude palm kernel oil. On the other hand, FUPO is a cash settled contract which does not involve physical delivery of the underlying crude palm oil.

 

• Equity futures. Equity futures are futures contracts based on shares or the stock index. The equity futures that are being traded on Bursa Malaysia Derivatives are the FTSE Bursa Malaysia KLCI Futures (FKLI) and Single Stock Futures (SSFs).

The FTSE Bursa Malaysia KLCI Futures (FKLI) is based on the Bursa Malaysia composite index, FBM KLCl, which is a weighted index of market capitalisation of 30 stocks of Malaysian companies listed on the Bursa Malaysia. FKLI is a cash settled contract. Upon expiration, any outstanding contracts are settled by reference to the price of the underlying stock index.

The Single Stock Futures (SSF) contract is based on a selected underlying single stock listed on the exchange. With SSF, investors are able to take a position in the underlying stock without up-front commitment of purchasing the shares and still be able to enjoy the same capital gain when the price of the underlying stock appreciates. However, SSF holders are not entitled to receive dividends or any of the share rights such as taking part in shareholder meetings as they are not actual shareholders of the company.

 

• Interbank offered rate futures (Interest bearing futures). The Kuala Lumpur Interbank Offered Rate or KLIBOR futures are based on a three-month interbank deposit in the Kuala Lumpur wholesale money market with a three-month maturity. The futures price is quoted as an index calculated at 100 minus the interest rate per annum. For example, a deposit quoted in the cash market at the rate of 7.5% would have an index price of 92.5 in the futures market. This means that when interest rates fall in the cash market, a long futures position (i.e. bought futures position) increases in value. As interest rates rise, the futures position falls. The users of KLIBOR users are mostly commercial banks, investment banks, discount houses, Cagamas, finance companies and insurance companies.

 

• Malaysian Government Securities (MGS) bond futures. The MGS Futures are contracts to make or to take delivery of Malaysian Government Securities (MGS) at a future date. Similar to interest rate futures, bond futures are also used as a hedging instrument for financial institutions and private corporations with short, medium to long term interest rate exposures to effectively manage their debt and fixed income portfolios.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Part 2

Basic futures trading strategies

(Hedging)

Many futures market traders are hedgers. They trade the futures contracts in order by taking a position that neutralises the risk as much as possible. This is especially common in the commodity futures market. There are basically two kinds of hedges that can be taken. For example, a company that wants to sell crude palm oil at a particular time in the future can hedge by taking a short futures position in the Crude Palm Oil Futures contracts to lock in the selling price in advance, especially if there is an expectation that the price of the commodity is going to drop. This is called a short hedge. On the other hand, a company that knows that it is due to buy crude palm kernel oil in the future can eliminate the price uncertainty by adopting a long futures position in the Crude Palm Kernel Oil Futures contracts to lock in the buying price now. This is also known as long hedge.

Index futures contracts can also be used by investors who are holding portfolios that closely track the stock market to gain protection against market declines. An investor who holds stocks on the blue chip companies listed on the Bursa Malaysia can choose to take a short position on the FBM KLCI futures. In the event that the market goes downward, the profit obtained from the futures contracts will be used to offset the losses experienced in the stock holdings.

 

Speculating

Speculating is basically betting on where the market is heading based on the speculator’s expectation. While hedgers buy or sell futures contracts to protect them from the adverse price movement of the underlying instruments, speculators seek to profit from the anticipated increase or decrease in the futures price. In doing so, the hedgers get to transfer their risk to the speculators. Therefore, the speculators face higher risks compare to hedgers in the pursuit of higher profits.

For example, an investor who expects the market to be on an upward trend in the near future can try to profit from the bull market by taking a long position on the FBM KLCI Index Futures. In doing so, he gets to profit from the market rally without having to make a large capital commitment to purchase physical stocks.

Arbitraging

Arbitraging using futures contracts is the simultaneous purchase of the physical asset against the sale of a futures contract, or vice versa, to lock in a minimum risk profit in the face of unequal prices. For example, an investor notices that the physical crude palm oil in the market is being traded at a lower price compare to the 2^nd month Crude Palm Oil (CPO) futures price. He then purchases the physical CPO and sells the 2^nd month futures. After one month, he can sell off the physical commodity and unwind or close out his futures position to realize the profit. However, investors must remember that in order to exploit an arbitrage opportunity, it involves simultaneous trading on the spot[2] and futures market. Therefore, one has to factor in the borrowing cost and storage cost into the arbitrage strategy.

 

Conclusion

 

The main advantage of trading in futures contracts is that it allows a high degree of leverage, which brings about the possibility of large returns, but, at the same time, the risk of large losses as it magnifies the effect of a small change in price. Due to the high degree of risk involved in high leverage, investors who want to get involved in futures trading should make sure that they are aware of the inherent risks in it first.