INTRODUCTION TO FUTURES

2.1
2.2
2.3
2.4

How the Futures Market Works

Using Futures to Hedge
Speculating with Futures
Arbitraging with Futures

INTRODUCTION
To examine the fundamental principles of futures

and look at how they are used by market

participants.
The main uses of futures are hedging, speculating
and arbitraging.
The main purpose of futures trading is to manage
price risk.
Act as risk-shifting mechanism risk can be
transferred from one party to another.

2.1 HOW THE FUTURES MARKET WORKS

Futures contracts are standardized legal

agreements to buy or sell a commodity or financial

instrument at some time in the future.
The quantity and quality of the goods are specified
in the contract.
The price and delivery period are set at the time the
contract is opened.

FUTURES ON WHAT?
Agriculture futures
Oldest and most basic commodities. Contract

include wheat, oats, corns, barley, cocoa & coffee

In Malaysia: Crude Palm Oil Futures which is traded
on MDEX.
Metals
Metals have been prized possession.
Precious metals: gold, silver, palladium & platinum
Industrial metals: copper, zinc, lead, aluminium & tin

Foreign Currency Futures

As exchange rates fluctuate in the world economy,

international and local investors, companies and

institutions, used it as protection for profit.
Energy
Futures contracts include crude oil, gasoline,

unleaded gasoline, heating oil and bunker fuel.

Interest Rate Futures

The most successful contract introduced worldwide
These contract can limit the risk from such changes-

a change in interest rate can affect the economy

Example: 3 month KLIBOR futures contract traded
on MDEX
Stock Index Futures
Each future contract represents the equivalent of a
stock portfolio in a major world stock market.
Example: FTSEBMKLCI futures contract traded on
MDEX.

REQUIREMENT FOR A VIABLE FUTURES MARKET

A deep market is needed the 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, and hence standardized grading

Payment has to be met at the time of delivery

Free fluctuation in order to create volatility, prices

must be free to fluctuate without any government

control and monopoly power.
To minimize the risk of default, buyers and sellers

have to establish financial responsibility.

CONTRACT SPECIFICATIONS
1. Underlying instruments
The particular commodity or financial instruments on which

the futures contract is based is known as underlying

instruments.
It may also be called the cash instrument , spot
instrument or physical instrument
Every futures market must have cash market. Example: in
the Malaysian futures trading MDEX is the futures
market, FTSEBMKLCI is the cash market
Example for underlying instruments: CPO futures is the
futures instruments while physical palm oil is the underlying
instruments.

2. Grade or quality
For physical commodity, the grade or quality of the

underlying instruments is specified in the futures contract

ensure every participant can trade with confidence,
knowing that all transactions are based on the same type
and quality.
3. Price Quotation
Future prices are quoted in the same basic units as the

underlying or spot price

Example: CPO futures prices are quoted in Ringgit
Malaysia per tonne because physical palm oil is also
quoted in Ringgit Malaysia per tonne.
The minimum fluctuation for this contract is RM1.

4. Contract size
The contract size is the amount of the underlying

instrument (number of units) that is covered by futures

contract.
For example, the size of the contract of CPO futures is 25
tonnes of palm oil. If you trade four contracts, you have an
underlying exposure of 100 tonnes.
5. Contract month
Traded in specific delivery month, which means they are

only available in certain months of the year.

This is justified because every futures market must have
the spot or current month and future or forward months.
Example: if it is April 2000, April is the spot month and May
and June are the forward months available for trading.

6. Expiry date
Each futures contract has an expiry date.
Expiry date is the last day of trading in the

particular contract month

After expiry date, the futures contract ceases to
exist.

PHYSICAL DELIVERY VS. CASH SETTLEMENT

Futures can be categorized into commodity and

financial futures
Commodity refers to anything that the land can produce
Financial refers anything that the land can trade.
Both futures require the buyer and seller to fulfill their

obligation either by:

1. Offsetting
By taking an opposite position (contra to the original)
Means- any opened contract or position can be closed

out prior to maturity.

Example: trader who has buying position can offset his
position by selling or vice-versa.
2. Settlement
Any outstanding contracts which is not yet closed out

must be settled at maturity.

Example: at the date of maturity, which is the last day
of trading for a given contract month, a trader will be
required by the exchange to settle his due contract.

3. Commodity futures
Based on physical commodity tangible
Have storage value & delivered physically
At maturity, all outstanding contracts in commodity

futures trading are required to be settled by physical

delivery.
4. Financial Futures
Based on financial instruments intangible
Not have storage value, cannot be delivered physically
To settle all outstanding contracts cash settlement at

maturity.

 Trading procedure buyer & seller settle their contracts

by cash
At maturity buyer will be a seller and a seller will be a
buyer at a settlement price determined by the clearing
house.
Both parties required to settle the cash price differentialdifference between the opening price (when contract was
opened) and the settlement price (when contract
expired) profit
At maturity, a loss to a buyer means a profit to a seller
and vice-versa.

TRADING PRACTICALITIES
Long vs. Short Futures Position
Long
Participant who bought a futures contract
Very bullish on its underlying in the future
Buying today at a lower price and expects to sell later at

a higher price.
Short
Participant who sell a futures contract
Very bearish on its underlying in the future
Selling today at a higher price and expects to buy back
later at a lower price.

Margin requirement - Normally 5%-10%

Initial margin (IM) - Represent a faith money
Maintenance margin
- Minimum amount to be maintained by an investor (set

below lower margin)

Variable margin-indicate IM will vary according to the

closing price (daily closing price)

Call Margin when amount below IM
Basis= Futures Price Cash Price

(+ve premium when FP>CP, -ve discount when FP<CP )

Convergence CP&FP converge at one price at

maturity (maturity price)

Volume num. of contract traded (Sales &Purchases
for a given contract month)
Open Interest-num. of outstanding contract for a given
month which is yet to be closed out or expired.
Contago FP > CP (normal)
Backwardation FP<CP (abnormal)
Usually FP>CP
Leverage- return on an investment exceed the return
on the underlying instrument.

2.2 USING FUTURES TO HEDGE

Hedging- limit the risks that arise from large fluctuations

in prices.
What is hedging?
Is taking a futures position in anticipation of a later cash

transaction OR
Taking a future position opposite to the current physical
position held.
2 types of hedging:

i.

ii.

Anticipatory hedging
Take a futures position as a substitute for a later cash transaction
Example: a palm oil producer who intends to sell his palm oil crops in
three months time, could fix the sale price forward by selling futures
contracts today.
Hedging a Current Market Position
Take a futures position that is opposite to the position you already have
in the cash market.
Example: an investment fund manager with a portfolio of shares (has
already bought shares) could hedge against a fall in stock price (and
hence, a fall in value of that portfolio) by selling stock index futures
contracts.

 Purpose of hedging: any loss you make in one market is

offset by a profit made in the other market.

(anticipated cash transaction or current market position)
Why hedge?
Hedging is about preserving and promoting wealth by

reducing exposure to financial and commodity price

movements, variable operating costs and income.
Hedging is a means of managing price risk.

ADVANTAGES OF HEDGING WITH FUTURES

i.

ii.

Liquid and central market

Liquid- refers to the high volumes and turnover that allow
traders to enter and exit the market quickly and easily.
Traded in one central market the exchange
Leverage
All participants are required to pay a margin on each
contract traded.
Any unrealised losses in the market must be paid up
regularly in the form of variation gains or losses
Leverage-ability to make large profits for relatively small
outlays of capital.

iii.

iv.

Positions May be Closed Out

A future contract is not held until maturity but closed out prior
to contract expiry by making an opposite transaction.
Example: if I had bought futures contract, I close my position
out by selling futures back into the market)
At the time closing out, I crystallise any profits or losses I have
made since the original transaction.
Convergence of futures and cash price
Future prices and cash prices for the same commodity in the
physical market tend to converge (ex: they draw together as
the delivery month approaches)
At expiry of the futures contract, the futures price will be the
same as the commodity price in the physical market.

DISADVANTAGES OF HEDGING WITH FUTURES

i.

Standardised Contracts
As futures are traded in contracts which specify an exact
quantity of a commodity, grade and expiry date, it is
unlikely that a hedger will be able to cover exactly the
amount and quality of commodity in physical market.
Example: a hedger who wishes to hedge the purchase of
85 tonnes of palm oil, using CPO futures, cant able to
hedge this full amount.
The contract is 25 tonnes of palm oil, so the hedger would
trade either 3 contract (under hedged) or 4 contract (over
hedged)

ii.

iii.

Initial and Variation Margin

All futures position are margined.
First margin - is an initial margin
Variation margin required if the futures position shows a
loss.
Very unique to futures must be funded by hedger.
Forgo Benefits of Favourable Movements
It prevent the hedger from benefiting from favourable price
movements.

IMPLEMENTING A HEDGE
HOW MUCH TO HEDGE?
Depend partly on the individual hedgers opinion of the

probable direction of cash prices between the time of the

hedge and the time at which the product will be bought or
sold.
A hedger should look to cover around 60% to 70% of his
projected sales or purchases
As a hedger, it is not generally recommended to hedge the
whole amount of his production would miss out on a
favourable price in the cash market.

WHICH DELIVERY MONTH TO USE?

Depend on the timing of the expected cash transaction

in the physical market.

Ideal situation when the futures contract expires at the
same time as the cash transaction takes place.
So, a borrower who wants to hedge a borrowing two
months from April, would use June KLIBOR futures.
Best situation to trade a future contract that expires
after the final cash transaction takes place.
So, if a borrower expected to borrow funds in August,
September futures would be used as a hedge.

BUY OR SELL FUTURES

The anticipatory hedger takes the same position today in the

futures market (intends taking at a later date in the physical

market).
Example: a gold miner who intends selling gold in six months
time would hedge this transaction by selling good futures
today.
To hedge a current market position, take the opposite position
in the futures market.
Already held in the physical or cash market
Example: a fund manager who currently holds a portfolio of
shares (has already bought shares) can hedge against a fall
in value of this portfolio by selling stock index futures.

HEDGE IMPERFECTIONS
Basis Risk
3 types of basis risk:
i. Delivery basis
Relates to the cost of delivery under a deliverable future
contracts. Cost of delivery include cost of funding, storing,
insuring the commodity until delivery. Under cash-settle
contracts, there are no delivery of commodity occurs.
ii. Grade basis

Not provide complete protection on grade basis because the

grade of physical commodity in which the hedger trades may
not match the standard futures grade.

iii. Location basis

Prices tend to vary between markets in different areas.
(oil palm grower in Johor using futures to hedge but selling
his crop close by through private treaty auction price for
the same types at the major selling centers)

Amount hedged
Futures amount are standardised (Ex: KLIBOR futures
contract only trades in lots of RM1m. So, if the trades want
an investment RM2.2m - in this case the hedge amount
would be RM2m only)
Timing diff in time, diff in price
Designated contract month

Example: KLIBOR futures are not settled in each

month of the year contract settlement months are
March, June, September and December.

2.3 SPECULATING WITH FUTURES

Speculators-deal with changes in the expected price
levels over time
Speculators profit from futures trading - by buying
contracts at a low price and selling them at a high price.
The Role of Speculators:
Speculators are attracted to the futures market due to:
i. High leverage huge profit potential, i.e. the outlay of a
small initial margin can lead to large profits.

ii.

Low transaction costs and commission compared to

the stock market or property market.

iii. Both large and small traders have equal access to the

market price, i.e. the interbank market , where bid and

offer prices quoted in the interbank market are
narrower than in the retail market.

OUTRIGHT POSITIONS
Speculators put up risk capital in hoping of making a

profit from the correct judgment of future price trends.

They buy futures if they believes prices will rise and sell
if they think prices to go down.
They use tools of fundamental analysis to help them
make some predictions, example:
i. The study of supply and demand
ii. The use of price and volume charts, to help form these
opinions.

TYPES OF SPECULATIVE TRADERS

Speculative traders who take outright positions may be

classified according to the types of traders they

undertake:
i. Scalpers goes for minimum price fluctuation on heavy
volumes. Taking only small profits or small losses.
ii. Day traders does *intra-day trading and differs from the
scalper in that his volumes are smaller.
iii.Position traders look at long term price trends. They
open position and hold it over a period of days, weeks or
months. Position will be closed when the price has
moved favourably.
*trading for one day only.

SPREAD TRADING
Form of speculative trading that involves the

simultaneous purchase and sale of related contracts.

Aim is to profit from a change in the difference between
the two future prices.
Less risky than outright position
3 general types of spread trades:
i. Inter-market spread (same product, diff market)
The market inter-market spread is different whereas
the month and commodity are the same
Example: Buying May Rubber Futures at the MDEX in
Malaysia and selling May Rubber Futures at the Osaka
Rubber Futures in Japan.

ii.

Inter-Month Spread (Intra-Commodity)

The contract month is different whereas the market
and commodity are the same.
Example: Buy May CPO Futures and sell July CPO
Futures at the MDEX.

iii. Inter-Commodity Spread

The market and month will be the same and

commodity will be different but it can be

economically related.
Example: Buy July CPO Futures and sell July Palm
Kernels Futures at the MDEX as both instruments are
economically related to the physical palm oil.

WHY TRADE SPREAD?

The trader can lock in the price differential between

the long and short of the spread, often by specifying the

exact differential.
The trader can ensure a favourable buying and selling
price and undertakes less risk.
Spread trades usually incur lower margins and
commissions
Makes them an attractive strategy for the speculative
trader.

2.4 ARBITRAGE WITH

FUTURES
Arbitrage is the simultaneous purchase and sale of

the same instrument in different markets to profit from

price discrepancies.
Ability to take advantage of different rates, prices and
condition between different markets.
The Role of Arbitrageurs
Providing liquidity in futures markets
Ensuring the convergence of cash and futures prices

towards the expiry date.

 How they ensure price convergence?

An arbitrage is a trade that involves buying a commodity

in one market (e.g. the physical market) and

simultaneously selling an identical amount of the
commodity in another market (e.g. the futures market) at
a higher.
After several traders have identified the arbitrage
opportunity and act on it, the selling in the futures
market, where prices are high, will push prices back to
their fair value as determined by prices in the physical
market and the time to futures contract expiry.

These natural market forces supply and demand.

Ensure by the time the futures contract reaches the

expiry date, both the futures price and the underlying

physical price are the same.
Futures Fair Value
FV - price at which a futures contract should

theoretically trading.
Future price = current price of the underlying commodity
+ cost of carry.
Cost of carry current interest rate, the return on the
underlying commodity, storage costs and actual time to
expiry.

ARBITRAGE TRADES
An arbitrage opportunity becomes available when

actual futures price move significantly away from fair

value.
Arbitrage trades riskless trades
If FP > FV a trader can make riskless profits by
simultaneously buying the underlying instrument and
selling futures.
If FP < FV a trader can make riskless profits by selling
the underlying instrument and buying futures.
To ensure cash and future prices remain highly
correlated and converge towards contract expiry.

QUESTIONS
Provide a short answer to the following questions:
Activity 1:
a) What is the function of delivery in a futures contract?
b) What happens on the expiry date if a contract is cash-settled?
c) Explain the concept of leverage in the futures market.
d) If I am long in the futures market, does this mean I have bought or sold
futures?
Activity 2:
a) Explain the difference between anticipatory hedging and hedging a current

market position.
b) List 5 advantages of hedging using futures
c) What is convergence?

Activity 3:
a) In your own words, briefly describe the importance of speculators to the
successful operation of the futures market.
b) List 5 reasons why traders/speculators are attracted to the futures market
c) Give the other name for a calendar spread.

ASSIGNMENT 2 (submit on 21/6-Tuesday-cover, GREEN)

1)
2)
3)
4)
5)
6)
7)
8)
9)
10)
11)

Does hedging necessarily improve the competitive position of a

corporation?
Define basis
Why is it important for hedgers to be aware of basis?
If KLSE CI futures are at 1150, the cash price is 1145, and the fair value
price for futures is 1157, what is the basis?
What is the importance of the speculators in the futures market?
Why is speculating considered risky?
Explain the difference between an intra commodity spread and an inter
commodity spread.
Explain how natural market forces act as a buffer against wide
discrepancies between cash and futures prices in the delivery month.
Explain the meaning of the terms contago and backwardation in the
context of the futures market
Which is more common: contago or backwardation?
How do arbitrageurs ensure that cash and futures prices converge
toward expiry