Chapter 5:

EǪUITY
PREPARED BY: FUTURES
DR. NUR ZAHIDAH BAHRUDIN
INTRODUCTIO
N
Financial futures can be in the form of tangible asset (ie: currency and bond futures) or intangible
asset (ie: index and interest rate futures).

This book only focus on index and interest rates as well as bond and stock futures.

Index futures are technically related to equity futures because index measures the performance of a
given stock market.

Equity represents an ownership of stockholders, and related to the trading of ordinary shares at the
stock exchange.

A stock index serves as a measure, or index of stock market performance.

Every stock market has its official index, and for Malaysia, the stock exchange is Bursa Malaysia
Securities Berhad with the official index is KLCI.
 THE UNDERLYING INSTRUMENT
● KLCI become the official index for Malaysia to meet the international standard.
● As the national index, KLCI measures the general and overall performance of the
Malaysian stock markets.
● KLCI futures are the derivative instruments and KLCI is the underlying
instrument.
● KLCI futures can be referees as the futures index, while KLCI as the cash index.
● It is an agreement between two contracting parties, seller and buyer to make and
take delivery of the basket of shares that make up the index, at an agreed price at a
specified futures date.
● Must be settled by cash settlement at maturity based on the price of the
underlying stock index.
CONTRACT
SPECIFICATIONS
The Mechanics of Trading
1. HEDGING WITH KLCI FUTURES

● Hedgers are the actual owners of the underlying instrument.

● KLCI futures, hedgers are buyers and sellers of physical shares.
● Institutional investors or portfolio managers use KLCI futures to protect their exposure in the
BMSB (cash market).
● Asset management company or the fund(portfolio) managers should be in position to reduce
their risks in the BMSB by hedging with KLCI futures.
● To hedge index futures, manager should calculate the number of contract by considering
percentage to hedge and beta of the portfolio.
 HEDGING AGAINST RISING PRICES (Buying/long hedge)
Will be established in anticipation of rising
prices, a cause for concern for potential
buyers. Investors who have an intention to
buy physical shares on the near future are
worried about steady increases in prices,
therefore they wish to hedge away the risks.

As a corporate planner of a state-owned unit trust company, you

anticipated to pool RM100 million in September. Today, early July,
cash index stands at 1055 in BMSB while September futures
index quotes at 1070 in BMDB. Assuming you plan to fully
hedge and your portfolio has a portfolio beta of 0.92, show your
hedging benefits if both prices converged at 1100 in September.
 Information given Later:
today: KLCI 1055 KLCI 1100 (converged with KLCI
KLCI futures 1070 futures) KLCI futures 1100
Beta = 0.92 Long hedge - because expect index to
% hedge = 100% (fully) rise

NOC: Amount to hedge x % of hedge x Beta

Value of contract (Opening price of futures x index
RM50)
= RM100m x 100% x
0.92 1070 x RM50
= 1720 contracts

L
o
Stock market Futures market
n
g
Expect to pool RM100m in September to Opening Contract
Early July be invested in BMSB.
h Current index Buy September 1720 KLCI
(Today) = 1055 e futures @1070
(Expect index tod increase, hence buy
futures) g
e
End September Pooled RM100m to buy physical Offsetting Contract
(Later) shares at higher prices and current Sell September 1720 KLCI
index = 1100 Futures @1100
(Rising index as expected)
Hedging benefits:

1. Futures Position = (Sell - Buy) x NOC x KLCI index

2. Cash position

Increase in Price = (Ending Price - Beginning Price) x Portfolio

Beginning Price
3. Net Effect = Futures position +/- cash position
4. Effective price = Total cost of purchasing NOC x
(index) RM50
Hedging benefits:

1. Futures Position = (Sell - Buy) x NOC x KLCI

index

=(1100 - 1070) x 1720 x RM50

=+RM2,580,000
2. Cash position
Due to change in index/price of
stock, the portfolio manager has
Increase in value = (Ending Price - Beginning Price) x Portfolio to pay additional of RM4.2m to
Beginning Price purchase physical shares in
BMSB. Hence, a cash loss. It is an
=1100 - 1055 x 100,000,000
extra cost of investment.
1055
=+RM4,265,403
3. Net Effect - By hedging, profit in futures will
cover losses in cash market
= Futures profit -
Addition cost in cash
market
● = RM2,580,000 -
The additional cost of buying physical shares will be reduced from RM4,265,400 to RM1,685,400 because of the profits made from futures.
RM4,256,400
Futures profit of RM2,580,000 is used to cover rising cost of buying physical shares.
= - RM1,685,400

4. Effective price = Total cost of purchasing

(index) NOC x RM50

Without hedging = RM100,000,000 + With hedging = RM100,000,000 + RM1,685,400

RM4,265,400 = 1720 x RM50
1720 x RM50 = 1182
= 1212
 HEDGING AGAINST FALLING PRICES (Selling/short hedge)

As investment director of fund management, you anticipate BMSB is to experience another

downtrend between today (June) and near future (September). Currently, KLCI at BMSB is at 1100while
September KLCI futures at 1010, and you are managing a portfolio worth RM50 million. You decided to
hedge 80% of your portfolio with a beta 1.15. As expected, end September, cash index closes at 980
while futures index at 930. Establish you hedging strategy by showing your hedging benefits.
 Information given Later:
today: KLCI 1100 KLCI 980
KLCI futures 1010 KLCI futures 930
Beta = 1.15 short hedge - because expect index to
% hedge = 80% from fall
RM50mill

NOC: Amount to hedge x % of hedge x Beta

Value of contract (Opening price of futures x index
RM50)
= RM50m x 0.80% x
1.15 1010 x
RM50
= 910
Short hedge

Stock market Futures market

Managing RM50mill portfolio and to Opening Contract

Early July hedge RM40mill.. Current index = Sell 910 September KLCI
(Today) 1100 futures @1010
(Expect index to fall, hence sell
futures)

End September Hold/Sell RM50mill of portfolio at lower Offsetting Contract

(Later) price. Buy 910 September KLCI
(Falling index to 980) Futures @930
Hedging benefits:

1. Futures Position = (Sell - Buy) x NOC x KLCI index

=(1010- 930) x 910 x RM50

As a result of decrease in
=+RM3,640,000 price,a portfolio manager
receive RM4,363,600 from
selling physical shares. The
2. Cash position KLCI index has decrease of
RM4.36mill.
Decrease in value = (Ending Price - Beginning Price) x Portfolio
Beginning Price
=980 - 1100 x 50,000,000
1100
=-RM5,454,545 (amount of loss Instead of losing Rm5,454,545 of
in investment value) investment value, the value of
investment will drop only by
3. Net Effect - By hedging, profit in futures will cover losses in cash market RM1,814,545 because it has been
= Futures profit - Loss in cash market covered by profit from futures
contracts.
= RM3,640,000 - RM5,454,545
= - RM1,814,545

● Lower revenue from selling physical shares will be reduced from RM5,454,545 to only RM1,814,545. Futures profit RM3,640,000 used to cover
falling revenue from selling physical shares.

4. Effective price = Total cost of purchasing

(index) NOC x RM50

Without hedging = RM50,000,000 + With hedging = RM50,000,000 + RM1,814,545

RM5,454,545 = 910 x RM50
910 x RM50 = 1059
= 979
 Example JUNE
2016
A fund manager is responsible for a RM7.5 million share portfolio that closely tracks
the FBM KLCI. Fearing a decline in the market, the manager decides to hedge 80
percent of his position today, March 1, using the FKLI. The index stands at 1678.5
while the FKLI, maturing in June is trading at 1692.
In May, the market falls as expected. The index stands at 1648.5 and June FKLI
trades at 1652.

i) Calculate the number of contracts to trade.

ii) Outline a strategy that the manager could profit from the situation.

iii) Show the profit or loss and comment on the outcome of the strategy.
i) Number of contract to trade.

NOC = (RM7.5 million x 80%)

1692 x RM50
= 70.92 @ 70 contracts

The manager should sell 70 June FKLI contracts at 1692 and later lose out the position accordingly. The detail are as
follows.

Short hedge

Stock market Futures market

Hold RM7.5 million portfolio of shares. Current Opening Contract

Early April index is 1678.5. (expect price to fall, so sell Sell 70 June FKLI at 1692
(Today) futures)

June Sell 7.5 million portfolio. The index stands at Offsetting Contract
(Later) 1648.5. Portfolio has fallen in value. Buy 70 June FKLI at 1652
Hedging benefits:

1. Futures Position = (Sell - Buy) x NOC x KLCI index

= (1692 - 1652) x 70 x RM50 = RM140,000

2. Cash position

Decrease in Price = (Ending Price - Beginning Price) x Portfolio

Beginning Price
= (1648 - 1678.5) x RM7.5 million
1678.5
=(RM134,048.26)
This implies that as a result of decrease in price, a portfolio manager receive
RM134,048.26 from selling physical shares. In other words, the KLCI index has fallen by
1.81%
3. Net Effect = Futures position + cash position
= 140,000 - 134,048.26
= 5952
(7.5 mill - 134,048.26)
Although the manager’s portfolio has decline to RM7,363,717.60, he still
made a net profit from hedging his position. The futures profit of RM140,000
will be used to offset his loss in the cash market.
 2. SPECULATING WITH KLCI FUTURES
● Speculators make money during bullish market or bearish market, whenever their
expectations come true.

Speculative Selling

As an experienced speculator, you believe that share prices at the BMSB will be at a
downward direction in the near future. You asked your broker to short 20 KLCI futures
contracts at a price of 956. Assuming you are required to pay initial margin of
RM3,750 per contract and maintain 80% of it, prepare your market-to-market position
on the following closing prices (index):
Day 1: 950
2: 942
3: 931
4:936
5:940
 Speculative Selling - MARKET BEARISH
Strategy: selling the futures contract because the index is
Initial margin = expected to fall.
RM75,000
Maintenance margin = 0.8 x RM75,000 =
RM60,000
Trading Day Settlement Price Floating Profit or Loss Current margin

0 956 (short) - RM75,000

1 950 (956 - 950) x 20 x RM50 RM81,000

RM 6,000

2 942 RM8,000 RM89,000

3 931 RM11,000 RM100,000

4 936 -RM5,000 RM95,000

5 940 -RM4,000 RM91,000

Profit/Loss on day 5 = (956-940) x 20 x RM50 =

RM16,000
Leverage effect on day 5
[(956-940)/940]
Price change = Selling - Buying x 100%
Buying
= 1.7%

Rate of return = +RM16,000 X 100%

RM75,000
=21.3%

Price change is only 1.7% (small change) but the change in rate of return is 21.3% (big profit).
This investment has provided a return of 12 times greater than the price change.
3. SPREADING WITH KLCI FUTURES
● Taking two opposite positions simultaneously.
● Lock in spread.

● Inter-month spread- contract which is quoted at higher price will be sold and at the same time another contract
with lower price will be bought.

● Spreader buy futures of anticipated bullish prospect, and simultaneously sells underperformed market (bearish
prospects).

● For instance, a spreader believes that the BMSB will outperform the Hong Kong Stock Exchange between
today and two month’s time. Hence, spreader will buy KLCI futures and sell Hang Seng index futures.

Strategy : Either to buy or sell

Buy futures in outperformed market, simultaneously

Sell futures underperformed market

Despite the gradual recovery of the world economy, the stock markets have been performing reasonably
well. A trader believes that the United States stock market, represented by the Standard & Poor 500 (S&P
500) index is expected to outperform the Malaysian stock market, represented by the FBM KLCI in the next
few months. The following data is available to the trader.

September KLCI Futures 1850

September S&P500 Index Futures 2750

Exchange rate USD1 =RM3.92

S&P 500 Index contract value is S&P500 Index

times USD250

Describe the strategy that the trader should consider if he were to take advantage of this situation, and if at
maturity, both S&P500 and FKLI closed at 2790 and 1860 respectively, show the trader’s profit or loss
position in MYR.
From the question:
S&P 500 index is expected to outperform the Malaysian stock market = Buy S&P500, sell FKLI

Today: September KLCI Futures 1850

September S&P500 Index Futures 2750
Exchange rate USD1 RM3.92
S&P 500 Index contract value is S&P500 Index times USD250

Later: S&P500 2790

FKLI 1860

Strategy: The trader will execute inter-market spread to take advantage of the performance of two
different markets by buying the S&P500 futures and simultaneously selling the FKLI futures today.

1. Calculate the value of each contract and NOC:

FKLI 1850 x RM50 =
RM92,500 S&P5002750 x USD250 x RM3.92 =
RM2,695,000
Therefore, 1 contract S&P500 is RM2,695,000
RM92,500 = 29 contracts of FKLI
 Inter-month spread

Month S&P500 BMDB

Today Buy 1 contract S&P500 Sell 29 contract of FKLI @

index futures @ 2750 1850

Later Sell 1 contract S&P500 Buy 29 contract of FKLI @

index futures @ 2790 1860

Profit/Loss:

FKLI = (Sell-Buy) x NOC x RM50 =(1850 - 1860) x 29 x

RM50
= - RM14,500
S&P500 =(Sell - Buy) x NOC x Contract value x exchange
rate
=(2790 - 2750) x 1 x USD250 x Rm3.92
=RM39,200
Gross Profit = -RM14,500 +
RM39,200
=RM24,700
4. ARBITRAGING WITH KLCI FUTURES

Arbitraging is taking two opposite positions in two different market (one in cash market and
simultaneously in futures market).

Arbitrage strategy established when there is significant difference between the calculated index
and the actual index.

Investor will calculate the future index based on the fair-value model and compare that to the actual
index to determine any overpricing or underpricing of the index

Overpricing index (Fair value < Actual value) - Sell the futures index

Underprice (Fair Value > Actual Value)- Buy the futures index

Fair value formula:

FV = KLCI + [KLCI x (cost of funds - dividend yield) (t/365)]

Example :

It is early October and you believe that quotations of KLCI futures in the BMDB are
mismatched. Currently, the spot index is quoting at 990 while November futures at 1060.
Assuming you trade 30 contracts and expect average dividend yield of 3.5% and risk-free rate
of 6.5% perannum, show your arbitrage activity and profit if both indices converged at 1020
in the last day of November with RM5 million fund.

Step 1: Calculate days to maturity

Sept (started to early Sept) (1-30) = 30 days

November (until end of November) (1-30) = 30

days So total days is 60 days

● Number of days must follow the actual

counting days in the particular month.
Step 2: Calculate the theoretical futures price
Fair Value = 990 +[990 x (0.065 - 0.035) x 60]
365
= 990 + 4.88
= 995
Step 3: Compare Fair Value to the Actual Price (futures price)
995 vs 1060

● October FKLI should be traded at 995 (fair price) not at 1060 (actual price), hence
October FKLI is overpriced. Therefore, Sell November FKLI, buy physical stock (KLCI)
in the cash market.

Step 4: Calculate NOC

= Portfolio amount x % arbitrage x beta of the investment
Value of contract
= RM5 mill x 100% x 1
RM1060 x RM50

= 94 contracts
 Cash and carry arbitrage

Time BMSB BMDB

Today (early October) Buy RM5 mill worth of Opening Position

physical shares @ 990. Sell 94 November KLCI
Hold temporarily futures @1060

Later (Late November) Dispose at maturity. Sell Settlement Position Buy

physical shares at a cost of 94 November KLC
RM5 mill @ 1020. futures @1020
Arbitraging benefit:

1. Futures = (Selling Price - Buying price) x NOC x RM50

Market
= (1060 - 1020) x 94 x RM50

= RM188,000

2. Cash Market
Increase in value = (Ending index - Beginning index) x Amount of Investment
Beginning Index

= (1020 - 990) x RM5,000,000

990

= +151,515 (additional value of the portfolio)

3. Interest expense = 0.065 x RM5,000,000 x 60

365
= - RM53,427

4. Dividend Revenue = 0.035 x RM5,000,000 x 60

(from investing in KLCI) 365
= RM28,767

5. Total Gross Profit = RM314,855

HOMEWORK/TUTORIAL

Hedging - January 2018 (Q3), December 2018 (Q3)

Speculating - August 2018 (Q4)

Spreading - December 2016 (Q1), June 2018

Arbitraging – July 2017 (Q3), December 2019 (Q3b),

February 2023 (Q3)