Demand of Derivatives Investment in Malaysia

Demand of Derivatives Investment in Malaysia ABSTRACT This research investigates the demand of derivatives investment by Malaysia. On the whole the main purpose of this dissertation is to study, analyse and discuss about the usage of derivatives by Malaysian company or individual resident. The research paper is divided into five chapters. Chapter 1 introduces derivatives and identification of the research problems. Research objectives and questions are given briefly. Chapter 2 provides an overview of the literature reviewed throughout the research. A detailed description by past researchers is presented. The further detail of each derivative contract are summarised. Chapter 3 deals with the work flow of this study. The research methodologies includes research design and procedure, data collection method, and statistical data analyses method. Data collection from secondary data is analysed to form a theoretical framework. Chapter 4 present the analysis and result of research topic. Tables, diagrams, charts are use to illustrates the findings. Finally, Chapter 5 concludes the dissertation with summary all of the chapters. CHAPTER 1 INTRODUCTION Introduction A derivative is a financial instrument that is derived from assets, indexes, events, value or condition (known as the underlying asset). Rather than trading or exchanging the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. (David, 2003) From definition taken from International Accounting Standards 39 (IAS39) Financial Instruments Recognition and Measurement, a derivative is a financial instrument whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rate, a credit rating or credit index or similar variable. (IAS, 2009) Forward contracts, futures contracts, options and swaps are the most common types of derivatives. Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative. (Khanna, 2010) Research Problem The research problem of this study is to uncover the derivative investment as a financial instrument for business and gaining capital. The usage of derivatives is getting larger nowadays. However, there is some criticism regarding the derivative in negative aspect as well. Research Objectives The following are the specific objective to achieve under this research To study the factor influence Malaysian to invest in the derivatives investment. To identify the method of reduction in risk under the usage of derivatives. Research Questions Questions that are bound to be answered throughout the research are: Why do investors select derivative investment? How can derivatives instrument be use? What is the types of derivative that are highly demanded in Malaysia? How does reduction in risk achieve by using derivatives instrument? How do traders speculate in order to make profit via derivatives? Scope of Study The scope of study for this research focuses on the derivative instruments. Significance of Study The significance of this study is to give the investors an idea as how the derivative instruments work in the business world. It also a study that helps businessman to reduce their risk and speculator to gain short-term money through derivatives. CHAPTER 2 LITERATURE REVIEW Introduction of Derivatives The first derivatives contract was listed in the year 1865 by the Chicago Board of Trade (CBOT) in USA. Those exchange traded derivatives contracts were called futures contracts. In April 1973, the Chicago Board of Options Exchange (CBOE) was set up for the purpose of options trading. The Standard Poors 500 Index in USA currently is the most popular stock index futures contract in the world. (HSBC Invest Direct, 2010) There are two distinct groups of derivative contracts, which tell apart the way they traded in the market. Over-the-counter (OTC) derivative is a type of financial derivative that negotiated directly between two parties rather than through an exchange centre. The OTC derivative market is the largest market for derivatives, and is unregulated with respect to disclosure of information between the parties. (Essaddam, et al., 2008) Exchange-traded derivative (ETD) is a type of financial derivative that has its transaction traded via specialised derivatives exchanges or other exchanges, such as Bursa, CBOE, Eurex etc. Derivatives exchange act as an intermediary to all related transactions, ETD is usually traded in standardised derivative contracts. (ISDA, 2009) There are few major derivative contracts which consist of forward, future, option and swap contract. Forward Contract A forward contract is a contract negotiated at present that gives the contract holder both the right and full legal obligation to conduct a certain asset transaction at a specific future time, amount, price and other terms. (Schweser, 2002) The party to the forward contract that agrees to buy the financial or physical asset has a long forward position and is called the long. The party to the forward contract that agrees to sell or deliver the asset has a short forward position and is called the short. (David, 2003) For instance, Lam Soon Company signed a contract under which they agree to buy a tonne of crude palm oil (CPO) from their supplier 30 days from now at a price of RM2,500. Lam Soon Company is the long and the supplier is the short. Both parties have removed uncertainty about the price they will pay or receive for the CPO in the future date. If 30 days from now CPO are trading at RM2,580 per tonne, the short (supplier) must deliver the CPO to the long (Lam Soon) in exchange for a RM2,500 payment. If CPO are trading at RM2,420 on the future date, the long must purchase the CPO from the short for RM2,500, the contract price. Forward contract is usually negotiated directly between the two parties, therefore it is an OTC market forward contract. The forward contracts have the advantage of being flexible (the parties design the contract to meet their specific needs). However, Stalla (2000) had concluded that forward contracts have three major disadvantages: They are illiquid. Because the terms of a forward contract are usually designed to meet the specific needs of the contracting parties, it is difficult for either one of them to close out its side of the contract, either by selling it to a third party or by getting the counterparty to cancel the agreement without demanding an excessive buyout price. They have credit risk. Forward contracts usually require neither party to the agreement to post collateral, make any mark-to-market transfers of funds over the life of the contract, or make any margin deposits to give assurance that it will be able fulfil its obligations under the terms of the agreement (although such clauses could be inserted into a forward contract by mutual consent of the parties). Consequently, a typical forward agreement is based on trust, each party to the agreement must trust that its counterparty will perform in the agreed-upon manner. This exposes both contracting parties to the risk that the counterparty might default on its obligation. They are unregulated. No formal body has the responsibility of setting down rules and procedures designed to protect market participants. Generally, the only protection given to parties involved in the OTC forward market is that of contract law. Future Contract A futures contract is a forward contract that has been highly standardised and closely specified. As with a forward contract, a futures contract calls for the exchange of some goods at a future date for cash, with the payment for the goods to occur at the future delivery date. The purchaser of the contract is to receive delivery of the good and pay for it, while the seller of the contract promises to deliver the goods and receive payment. The payment price is determined at the initial time of the contract. (Adhar, 2006) Futures contracts are usually traded on futures exchanges (ETD), rather than in an OTC environment. Hence, futures contracts are unique forms of forward contracts that designed to reduce the disadvantages of forward contracts. The future contracts terms have been standardised so that can be traded in a public marketplace. Due to standardisation, futures contracts are lesser flexible than forward agreements, hut it also makes them more liquid. (Copeland, et al., 2004) According to Schweser (2006) points, in order to safeguard the clearinghouse, which act as the buyer to every seller and the seller to every buyer, the exchange requires traders to post margin and settle their accounts on a daily basis. Before trading, the trader must deposit funds, called margin with their broker (who, in return, will post margin with the clearinghouse). The purpose of margin is to ensure that traders will perform their contractual obligations. There are three types of margin. The first deposit is called the initial margin which had been explained above. Any losses for the day are removed from the traders account and any gains are added to the traders account. If the margin balance in the traders account falls below a certain level (called the maintenance margin), the trader will get a margin call and have to deposit more money (called the variation margin) into the account to bring the account back up to the initial margin level. (Stalla, 2000) For instance, Lam Soon buys a 30 days future contract of CPO at RM2,500 per tonne. The initial margin was RM2,500. The next day the price of CPO plummetsRM50. Therefore Lam Soon has just lost RM50. At the end of the day, the daily settlement process marks Lam Soons margin account to market by taking RM50 out of the account leaving a balance of RM2,450. Now, assume the maintenance margin level is at 70%. If Lam Soons margin balance falls to or below RM1,750, Lam Soon gets a margin call and has to bring their account back up to the initial RM2,500 level. There are several advantages to using forward or futures contracts as a substitute for trading in the spot markets of commodities: (Sorid, n.d) Transaction costs are much lower and liquidity is better in the futures markets than in the spot markets. There is no need to store or insure physical assets if forward or futures contracts are used. Forward and futures contracts may be sold short, as well as bought long. This may not always be possible if one were trading the actual underlying assets themselves. There is a great deal of leverage in forward and futures contracts. A trader can control on a large position with only a small initial deposit. If the futures contract with a value of RM100,000 has an initial margin of RM10,000 then one percent change in the futures price which is RM1,000, would result in a 10 percent change relative to the traders initial costs. Since there is no margin is required with a forward contract, control can be obtained with no money down. There is flexibility, especially with forward contracts, that can be used to create specialized risk/return patterns. Price risk can be accepted or eliminated by using forward or futures contracts without compromising any holdings of an underlying asset. Thus, a jeweller can sell the price risk associated with holding an inventory of gold without actually disturbing the physical inventory itself. This makes it easy to adjust ones financial exposure to commodity markets, even if ones physical exposure must be maintained for business purposes. The primary disadvantage of using futures contracts for speculative trading would involve a great deal of leverage, so that large losses can occur. In effect, holding a futures position with only the margin requirement on deposit in a brokerage account is the same thing as having purchased the underlying asset on margin. Another closely related disadvantage is that futures (but not forward) contracts subject the trader to margin calls to meet daily settlement obligations. This requires participants to have a cash reserve that can be drawn upon to meet these demands for additional cash. (Sorid, n.d) Option Contract According to the Chicago Board Options Exchange (CBOE) 2008, an option is a contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. The owner of a call option has the right, but not the obligation to purchase the underlying good at a specific price for a specified time period. While the owner of a put option has the right, but not the obligation to sell the underlying good at a specific price for a specified time period. To qualify these rights, the options owner has to pay a premium to the seller of the option for buying the option. (CBOE, 2008) The seller of the option is called an option writer. Options have four possible positions: (CBOE, 2008) Call option buyer Call option writer or seller Put option buyer Put option writer or seller In these contracts, the rights are with the owner of the option. The buyer that pays the premium receives the right to buy or sell the underlying asset on specific time and price. The writer or seller of the option receives payment and obligates to sell or purchase the underlying asset as agreed in the contract of the option owner. (Akmeemana, n.d.) For instance, BAT share is selling at RM50 while its call option is at RM10. The call option can be exercised for RM45 with a life span of 5 months. The exercise price of RM45 is called the options strike price. The RM10 price of the option is called the option s premium. If the option is purchased for RM10, the buyer can purchase the stock from the option seller over the next 5 months for RM45. The seller, or writer of the option gets to keep the RM10 premium no matter what the stock does during this time period. If the option buyer exercises the option, the seller will receive the RM45 strike price and must deliver to the buyer a share of BAT stock. If the price of BAT stock falls to RM45 or below, the buyer are not obliged to exercise the option. Note that the option holders can only exercise their right to act if it is profitable to do so. The option writer, however, has an obligation to act at the request of the option holder. A put option is the same as a call option except the buyer of the put has the right to sell the put writer a share of BAT at any time during the next five months in return for RM45. The owner of the option is the one who decides whether to exercise the option or not. If the option has value, the buyer may either exercise the Option or sell the option to another buyer in the secondary options market. (Tatum, 2010) For short-term investment horizons, options trading can produce lower transaction costs than the outright purchase and sale of the underlying assets themselves. Besides, options can he used to execute some tax strategies. (Skousen, 2006) Swap Contract A swap is an agreement between two or more parties to exchange sets of cash flows over a period in the future. The parties that agree to the swap are known as counterparties. The cash flows that the counterparties make are generally tied to the value of debt instruments or the value of foreign currencies. Therefore, the two basic kinds of swaps are interest rate swaps and currency swaps. (Schweser, 2006) Unlike the highly structured futures and options contracts, swaps are custom tailored to fit the specific needs of the counterparties. The counterparties may select the specific currency amounts that they wish to swap, whereas exchange traded instruments have set values. Similarly, the swap counterparties choose the exact maturity that they need, rather than maturity dates set by the exchange. This flexibility is very important in the swap market, because it allows the counterparties to deal with much longer horizons than can be addressed through exchange-traded instruments. Also, since swaps are not exchange traded, it gives the participants greater privacy, and they escape a great deal of regulation. (Hodgson, 2006) According to Hodgson (2996), the advantages of swap agreements over conventional traded derivatives can be summarised as below: Swaps are highly flexible and can be custom made to fit the requirements of the parties entering into them. The swap market is virtually unregulated, in contrast to the highly regulated futures market. This could change, however, since regulators usually abhor a regulation vacuum and probably will, eventually, seek to bring the market under their protection. The cost of transacting in the swap market is low. Swaps are private transactions between two parties. Often, swaps are off-balance sheet transactions that can be used, for example, to enable a firm to reposition its balance sheet quickly without alerting competitors. The disadvantages of swaps include: Because swaps are agreements, a party who wants to enter into a particular swap must find a counterparty that is willing to take the other side of the swap. Swaps can be illiquid; once entered into, a swap cannot easily be terminated without the consent of the counterparty. Because there are no margin deposits or a clearinghouse that help ensure, or will guarantee, that the agreements will be honoured, the integrity of swaps depends solely upon the financial and moral integrity of the parties that have entered into them. In other words, the swaps have more credit risk than futures contracts. The Demand of Derivatives Based on the statistics of the Bursa Malaysia Derivatives Berhad, the total exchange of derivatives during the year 2009 was up to 6,137,827 contracts. The crude palm oil futures (ETD) is the most liquid future in Malaysia, total of 4,008,882 contracts with average of 334,074 contracts traded monthly during year 2009. (Bursa Malaysia, 2010) Figure 2.1 shows the monthly price traded and the monthly volume of crude palm oil futures (FCPO) traded in Bursa Malaysia from year 1985 until March 2010. The green colour bar represents the price close on the month end was above the open price open on the beginning of the month, while red colour bar indicates the closing price is below the open price. Figure 2.1 indicates that there was less transaction traded during the eighth decade of the 20th century until 2002. The number of FCPO contract traded keep on increasing especially start from year 2002, and is quite popular in recent year, the volume of transaction exceeded 150,000 contracts each month. FCPO is extremely high volume in 2008 because the global oil price is at its peak at USD145 per barrel. FCPO traded at its pinnacle in November 2006 which recorded 360,650 contracts in a month. This showing that the FCPO is high in demand in Malaysia as compare to previous years. Figure 2.2 shows the history chart of FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures (FKLI) traded in Bursa Malaysia from December 1995 until March 2010. There was a high trading volume during the 1997 Asian Financial Crisis due to the high fluctuate of the Kuala Lumpur Composite Index (KLCI). 148,318 future contracts were traded in September 1998. There were at least 40,000 future contracts traded in the following years of 1998. The volume traded increasing rapidly in 2007 as Malaysian economy recovers. KLCI went as high as 1400 points during the last 3 years. 302,321 future contracts were trade in August 2007, which is the highest volume recorded in history. Based on Figure 2.2 trading volume trend, it can be concluded that speculators were heavily involve in trading FKLI in 1997, where the Asian Financial Crisis tragedy occurred and in its peak in 2007 . KLCI fluctuation was elevated during these two event (circled in the chart). For the global market, the market for options developed rapidly in early 80s. The number of option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. According to the Bank for International Settlements, the total OTC derivative outstanding notional amounted to USD605 trillion as of June 2009. Factors That Influence Derivatives Trading Mike Singh (2010) said that trading derivatives will have lesser risk than other trades because investor are not buying into the company or buying the underlying product. Instead, the risk is placed on performance. Due to its low risk factor, investment and commercial banks, end users such as floor traders, corporations, and mutual and hedge funds, are major types of firms that utilize derivatives. A much lower initial investment start up in derivatives trading, derivatives give an edge to those who decline or do not want to invest as much as is required to purchase stock. Derivatives can be a good way to balance ones total portfolio by spreading the risk throughout a variety of investments, rather than putting all eggs into a basket. Besides that, trading derivatives can be a good short term investment. Compared to some stocks and bond, derivatives is an financial instrument that can pay off in a shorter time frame such as days, weeks, or a few months. Stock and bonds are long-term investments and may over the course of many years. As the shorter turnaround time, derivatives can be a good way break into the market and mix short and long-term investments. (Siems, 1997) Numerous resources are available for learning about derivatives trading and many options are available. Hence derivatives are variety and flexibility, this point of view was supported by Mike Singh, 2010. Derivatives can derive profit from changes in equity markets, currency exchange rate, interest rates around the world. It also include the commodities changes in global supply and demand such as precious and industrial metals, agricultural products, and energy products such as petroleum and natural gas. This show that derivatives trading are available on a global scale. Getting involved in the global economy opens international options that may not be available through the traditional stock market. From the points given above, he concluded that there are three reasons for derivatives trading. First, trading derivatives are lesser risk than other trades. Second, trading derivatives are a good short term investment. Third, trading derivatives are variety and flexibility. Hence, derivatives trading may be a good trading option if someone are looking outside of trading traditional stocks and bonds. The International Swaps and Derivatives Association, Inc. (ISDA) announced the results of a survey done on the derivatives usage by the worlds 500 largest companies. According to the survey, 94% of these companies use derivative instruments to hedge and manage their financial risks in business. The foreign exchange derivatives are the most widely used instruments with total 88% of the sample, followed by interest rate derivatives which is 83% and commodity derivatives. There are two benefits which are most widely recognised attributed to derivative instruments, risk management and price discovery. Risk management could be the most vital purpose of the derivatives market. Derivatives also used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect, bearing extra risk by speculations. (Kuhlman, 2009) Price discovery is the prediction of information about future cash market prices through the futures market. There is a relationship between an assets current (spot) price, its futures contract price, and the price that people expect to prevail on the delivery date. By using the information contained in futures prices today, market observers can form estimates of what the price of a given commodity will be at a certain time in the future. Futures markets serve a social purpose by helping people make better estimates of future prices, so that they can make consumption and investment decisions more wisely. (Sorid, n.d) The derivatives market are broadly classified into three uses: Hedging Speculation Arbitrage Hedging Hedging is a way to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entitys other risks and uncertainties. (Elliot Elliot, 2005) One reason why companies attempt to hedge these price changes is because they are risks that are peripheral to the central business in which they operate. Hedging also refers to managing risk to an extent that makes it bearable. (Kameel, 2008) Equity Hedging Traders can use derivatives to hedge or mitigate risk in the stock market. Entering into a derivative contract can cover part or all of the losses if the value of their underlying position moves in the opposite direction. For equity forward contracts, where the underlying asset is a single stock, a portfolio of stocks, or a stock index, work in much the same manner as other forward contracts. An investor who wishes to sell 100 shares of BAT stock 90 days from now and wishes to avoid the uncertainty about the stock price on that date, could do so by caking a short position in a forward contract covering 100 BAT shares. A dealer might quote a price of RM48 per share, agreeing to pay RM4,800 for the 100 shares 90 days from now. The contract may be deliverable or settled in cash as described above. The stock seller has locked in the selling price of the shares and will get no more if the price (in 90 days) is actually higher, and will get no less it the price actually lower. (Sharma, 2009) For equity future example, an individual stock trader can minimise the stock trading risk by hedging using futures market (Exchange-traded derivatives). A stock trader is extremely aware of economy downturn. If the trader expected an economy downturn is coming which will cause the share price to drop, the trader can protect against down fall of stocks equity by opening a short position of the FTSE Bursa Malaysia KLCI Futures (FKLI) to hedge against his stock portfolio. So if the economy downturn does happen, the trader will gain profit from the FKLI. However, there will be a loss if the trader close the position of the stock during the economy downturn, but the gain from the FKLI will cover some or over the losses from the stock market. Thus, this can reduce the risk by FKLI futures hedging. (Copeland, et al., 2004) For stock option contracts, one call priced at RM6 with a strike price of RM30 gives the holder the right to purchase 100 shares of the stock at RM30 per share until the exercise date. The contract has a money value of RM600 (RM6 x 100 shares). For put options. the concepts are the same, except that the option gives the holder the right to sell 100 shares of the stated stock at RM30 per share through the exercise date. Commodity Hedging Commodity is a physical substance which there is demand, such as basic resources and agricultural. The most popular commodities in Malaysia include CPO, gold, tin, rubber and latex. (Amadeo, 2003) For instance, an airline company which the fuel is the biggest cost item for an airline taken care of, might want to get protection against the fuel price crisis. The airline company might enter into a future contract to hedge the fuel price. They will sign up a future contract with the fuel supplier (OTC derivative), promising that they will buy a certain amount of fuel at a certain price for the next certain months. The contract will definite the price that the airline company to pay for buying the fuel in future. In case the fuel price go higher than the contract price, then the fuel will have a cheaper price. If the fuel price gone down without the airline company expectation, which mean the contract price is higher than the market price, in that incident, the airline company might not want to exercise the contract price. In return, the airline company need to pay certain of fund to the fuel supplier as the contract fee. (Larry, 2005) Malaysian Airline System Berhad (MAS) announced a RM1.34 billion fuel hedge gain in the second quarter ended 30 June 2009. (Francis, 2009) Idris Jala (2009), the Managing Director and Chief Executive Officer of Malaysia Airlines said that he had decided not to unwind the fuel hedges so that the company can remain protected against the volatile fuel prices. MAS had hedged 47% of its fuel requirement at USD103/ bbl WTI for the year ended 2009 from 31 March 2009. Further highlighting the volatility of fuel prices, the fuel price increased 47% since April 2009, those airlines that did not hedge will be affected by the fuel price increasing, said Idris Jala, 2009. While MAS fuel bill increasing in tandem with the fuel price, MAS total fuel bill will be lower as the gains from the fuel hedges will partly offset the higher fuel cost. Foreign exchange (Forex) Hedging In international trading, dealings with forex play a significant role. There will be a significant impact on business decisions and outcomes if got any fluctuations in the forex rate. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Therefore, companies will use forex hedging with forwards, future, option. (Joseph Nathan, 1999) Forex hedging with forwards Forex forward rate is an agreement between two parties (OTC derivatives) to fix the exchange rate for a future transaction. In Malaysia, there are some banks do provide Forward Rate Agreements (FRA) service such as Bank Islam Malaysia, Maybank, EON Bank Group, CIMB Bank Group, HSBC Bank Malaysia, etc. A company simply transfer the risk to the bank when they entering into a FRA with a bank. Of course the bank internally will do some kind of arrangement to manage the risk. (Currencies Direct, 2010) For instance, a Malaysian construction company, Ban Lee Hin Engineering Construction Sdn Bhd just won a contract to build a bridge road in Philippines. The contract is signed for 10,000,000 Peso and would be paid for after the completion of the work. This amount is consistent with Ban Lee Hin minimum revenue of RM750,000 at the exchange rate of RM7.50 per 100 Peso. However, since the exchange rate could fluctuate and end with a possible depreciation of Peso, Ban Lee Hin enters into a forward agreement with Philtrust Bank in Philippines to fix the exchange rate at RM7.50 per 100 Peso. The forward contract is a legal agreement, and therefore constitutes an obligation on both parties. The Philtrust Bank may have to find a counter party for such transaction, either a party who wants to hedge against the appreciation of 10,000,000 Peso expiring at the same time, or a party that wishes to speculate on an increasing the value of Peso. If the Philtrust Bank itself plays the counter party, t hen the risk would be borne by the bank itself. By entering into a forward contract, Ban Lee Hin is guaranteed of an e Demand of Derivatives Investment in Malaysia Demand of Derivatives Investment in Malaysia ABSTRACT This research investigates the demand of derivatives investment by Malaysia. On the whole the main purpose of this dissertation is to study, analyse and discuss about the usage of derivatives by Malaysian company or individual resident. The research paper is divided into five chapters. Chapter 1 introduces derivatives and identification of the research problems. Research objectives and questions are given briefly. Chapter 2 provides an overview of the literature reviewed throughout the research. A detailed description by past researchers is presented. The further detail of each derivative contract are summarised. Chapter 3 deals with the work flow of this study. The research methodologies includes research design and procedure, data collection method, and statistical data analyses method. Data collection from secondary data is analysed to form a theoretical framework. Chapter 4 present the analysis and result of research topic. Tables, diagrams, charts are use to illustrates the findings. Finally, Chapter 5 concludes the dissertation with summary all of the chapters. CHAPTER 1 INTRODUCTION Introduction A derivative is a financial instrument that is derived from assets, indexes, events, value or condition (known as the underlying asset). Rather than trading or exchanging the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. (David, 2003) From definition taken from International Accounting Standards 39 (IAS39) Financial Instruments Recognition and Measurement, a derivative is a financial instrument whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rate, a credit rating or credit index or similar variable. (IAS, 2009) Forward contracts, futures contracts, options and swaps are the most common types of derivatives. Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative. (Khanna, 2010) Research Problem The research problem of this study is to uncover the derivative investment as a financial instrument for business and gaining capital. The usage of derivatives is getting larger nowadays. However, there is some criticism regarding the derivative in negative aspect as well. Research Objectives The following are the specific objective to achieve under this research To study the factor influence Malaysian to invest in the derivatives investment. To identify the method of reduction in risk under the usage of derivatives. Research Questions Questions that are bound to be answered throughout the research are: Why do investors select derivative investment? How can derivatives instrument be use? What is the types of derivative that are highly demanded in Malaysia? How does reduction in risk achieve by using derivatives instrument? How do traders speculate in order to make profit via derivatives? Scope of Study The scope of study for this research focuses on the derivative instruments. Significance of Study The significance of this study is to give the investors an idea as how the derivative instruments work in the business world. It also a study that helps businessman to reduce their risk and speculator to gain short-term money through derivatives. CHAPTER 2 LITERATURE REVIEW Introduction of Derivatives The first derivatives contract was listed in the year 1865 by the Chicago Board of Trade (CBOT) in USA. Those exchange traded derivatives contracts were called futures contracts. In April 1973, the Chicago Board of Options Exchange (CBOE) was set up for the purpose of options trading. The Standard Poors 500 Index in USA currently is the most popular stock index futures contract in the world. (HSBC Invest Direct, 2010) There are two distinct groups of derivative contracts, which tell apart the way they traded in the market. Over-the-counter (OTC) derivative is a type of financial derivative that negotiated directly between two parties rather than through an exchange centre. The OTC derivative market is the largest market for derivatives, and is unregulated with respect to disclosure of information between the parties. (Essaddam, et al., 2008) Exchange-traded derivative (ETD) is a type of financial derivative that has its transaction traded via specialised derivatives exchanges or other exchanges, such as Bursa, CBOE, Eurex etc. Derivatives exchange act as an intermediary to all related transactions, ETD is usually traded in standardised derivative contracts. (ISDA, 2009) There are few major derivative contracts which consist of forward, future, option and swap contract. Forward Contract A forward contract is a contract negotiated at present that gives the contract holder both the right and full legal obligation to conduct a certain asset transaction at a specific future time, amount, price and other terms. (Schweser, 2002) The party to the forward contract that agrees to buy the financial or physical asset has a long forward position and is called the long. The party to the forward contract that agrees to sell or deliver the asset has a short forward position and is called the short. (David, 2003) For instance, Lam Soon Company signed a contract under which they agree to buy a tonne of crude palm oil (CPO) from their supplier 30 days from now at a price of RM2,500. Lam Soon Company is the long and the supplier is the short. Both parties have removed uncertainty about the price they will pay or receive for the CPO in the future date. If 30 days from now CPO are trading at RM2,580 per tonne, the short (supplier) must deliver the CPO to the long (Lam Soon) in exchange for a RM2,500 payment. If CPO are trading at RM2,420 on the future date, the long must purchase the CPO from the short for RM2,500, the contract price. Forward contract is usually negotiated directly between the two parties, therefore it is an OTC market forward contract. The forward contracts have the advantage of being flexible (the parties design the contract to meet their specific needs). However, Stalla (2000) had concluded that forward contracts have three major disadvantages: They are illiquid. Because the terms of a forward contract are usually designed to meet the specific needs of the contracting parties, it is difficult for either one of them to close out its side of the contract, either by selling it to a third party or by getting the counterparty to cancel the agreement without demanding an excessive buyout price. They have credit risk. Forward contracts usually require neither party to the agreement to post collateral, make any mark-to-market transfers of funds over the life of the contract, or make any margin deposits to give assurance that it will be able fulfil its obligations under the terms of the agreement (although such clauses could be inserted into a forward contract by mutual consent of the parties). Consequently, a typical forward agreement is based on trust, each party to the agreement must trust that its counterparty will perform in the agreed-upon manner. This exposes both contracting parties to the risk that the counterparty might default on its obligation. They are unregulated. No formal body has the responsibility of setting down rules and procedures designed to protect market participants. Generally, the only protection given to parties involved in the OTC forward market is that of contract law. Future Contract A futures contract is a forward contract that has been highly standardised and closely specified. As with a forward contract, a futures contract calls for the exchange of some goods at a future date for cash, with the payment for the goods to occur at the future delivery date. The purchaser of the contract is to receive delivery of the good and pay for it, while the seller of the contract promises to deliver the goods and receive payment. The payment price is determined at the initial time of the contract. (Adhar, 2006) Futures contracts are usually traded on futures exchanges (ETD), rather than in an OTC environment. Hence, futures contracts are unique forms of forward contracts that designed to reduce the disadvantages of forward contracts. The future contracts terms have been standardised so that can be traded in a public marketplace. Due to standardisation, futures contracts are lesser flexible than forward agreements, hut it also makes them more liquid. (Copeland, et al., 2004) According to Schweser (2006) points, in order to safeguard the clearinghouse, which act as the buyer to every seller and the seller to every buyer, the exchange requires traders to post margin and settle their accounts on a daily basis. Before trading, the trader must deposit funds, called margin with their broker (who, in return, will post margin with the clearinghouse). The purpose of margin is to ensure that traders will perform their contractual obligations. There are three types of margin. The first deposit is called the initial margin which had been explained above. Any losses for the day are removed from the traders account and any gains are added to the traders account. If the margin balance in the traders account falls below a certain level (called the maintenance margin), the trader will get a margin call and have to deposit more money (called the variation margin) into the account to bring the account back up to the initial margin level. (Stalla, 2000) For instance, Lam Soon buys a 30 days future contract of CPO at RM2,500 per tonne. The initial margin was RM2,500. The next day the price of CPO plummetsRM50. Therefore Lam Soon has just lost RM50. At the end of the day, the daily settlement process marks Lam Soons margin account to market by taking RM50 out of the account leaving a balance of RM2,450. Now, assume the maintenance margin level is at 70%. If Lam Soons margin balance falls to or below RM1,750, Lam Soon gets a margin call and has to bring their account back up to the initial RM2,500 level. There are several advantages to using forward or futures contracts as a substitute for trading in the spot markets of commodities: (Sorid, n.d) Transaction costs are much lower and liquidity is better in the futures markets than in the spot markets. There is no need to store or insure physical assets if forward or futures contracts are used. Forward and futures contracts may be sold short, as well as bought long. This may not always be possible if one were trading the actual underlying assets themselves. There is a great deal of leverage in forward and futures contracts. A trader can control on a large position with only a small initial deposit. If the futures contract with a value of RM100,000 has an initial margin of RM10,000 then one percent change in the futures price which is RM1,000, would result in a 10 percent change relative to the traders initial costs. Since there is no margin is required with a forward contract, control can be obtained with no money down. There is flexibility, especially with forward contracts, that can be used to create specialized risk/return patterns. Price risk can be accepted or eliminated by using forward or futures contracts without compromising any holdings of an underlying asset. Thus, a jeweller can sell the price risk associated with holding an inventory of gold without actually disturbing the physical inventory itself. This makes it easy to adjust ones financial exposure to commodity markets, even if ones physical exposure must be maintained for business purposes. The primary disadvantage of using futures contracts for speculative trading would involve a great deal of leverage, so that large losses can occur. In effect, holding a futures position with only the margin requirement on deposit in a brokerage account is the same thing as having purchased the underlying asset on margin. Another closely related disadvantage is that futures (but not forward) contracts subject the trader to margin calls to meet daily settlement obligations. This requires participants to have a cash reserve that can be drawn upon to meet these demands for additional cash. (Sorid, n.d) Option Contract According to the Chicago Board Options Exchange (CBOE) 2008, an option is a contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. The owner of a call option has the right, but not the obligation to purchase the underlying good at a specific price for a specified time period. While the owner of a put option has the right, but not the obligation to sell the underlying good at a specific price for a specified time period. To qualify these rights, the options owner has to pay a premium to the seller of the option for buying the option. (CBOE, 2008) The seller of the option is called an option writer. Options have four possible positions: (CBOE, 2008) Call option buyer Call option writer or seller Put option buyer Put option writer or seller In these contracts, the rights are with the owner of the option. The buyer that pays the premium receives the right to buy or sell the underlying asset on specific time and price. The writer or seller of the option receives payment and obligates to sell or purchase the underlying asset as agreed in the contract of the option owner. (Akmeemana, n.d.) For instance, BAT share is selling at RM50 while its call option is at RM10. The call option can be exercised for RM45 with a life span of 5 months. The exercise price of RM45 is called the options strike price. The RM10 price of the option is called the option s premium. If the option is purchased for RM10, the buyer can purchase the stock from the option seller over the next 5 months for RM45. The seller, or writer of the option gets to keep the RM10 premium no matter what the stock does during this time period. If the option buyer exercises the option, the seller will receive the RM45 strike price and must deliver to the buyer a share of BAT stock. If the price of BAT stock falls to RM45 or below, the buyer are not obliged to exercise the option. Note that the option holders can only exercise their right to act if it is profitable to do so. The option writer, however, has an obligation to act at the request of the option holder. A put option is the same as a call option except the buyer of the put has the right to sell the put writer a share of BAT at any time during the next five months in return for RM45. The owner of the option is the one who decides whether to exercise the option or not. If the option has value, the buyer may either exercise the Option or sell the option to another buyer in the secondary options market. (Tatum, 2010) For short-term investment horizons, options trading can produce lower transaction costs than the outright purchase and sale of the underlying assets themselves. Besides, options can he used to execute some tax strategies. (Skousen, 2006) Swap Contract A swap is an agreement between two or more parties to exchange sets of cash flows over a period in the future. The parties that agree to the swap are known as counterparties. The cash flows that the counterparties make are generally tied to the value of debt instruments or the value of foreign currencies. Therefore, the two basic kinds of swaps are interest rate swaps and currency swaps. (Schweser, 2006) Unlike the highly structured futures and options contracts, swaps are custom tailored to fit the specific needs of the counterparties. The counterparties may select the specific currency amounts that they wish to swap, whereas exchange traded instruments have set values. Similarly, the swap counterparties choose the exact maturity that they need, rather than maturity dates set by the exchange. This flexibility is very important in the swap market, because it allows the counterparties to deal with much longer horizons than can be addressed through exchange-traded instruments. Also, since swaps are not exchange traded, it gives the participants greater privacy, and they escape a great deal of regulation. (Hodgson, 2006) According to Hodgson (2996), the advantages of swap agreements over conventional traded derivatives can be summarised as below: Swaps are highly flexible and can be custom made to fit the requirements of the parties entering into them. The swap market is virtually unregulated, in contrast to the highly regulated futures market. This could change, however, since regulators usually abhor a regulation vacuum and probably will, eventually, seek to bring the market under their protection. The cost of transacting in the swap market is low. Swaps are private transactions between two parties. Often, swaps are off-balance sheet transactions that can be used, for example, to enable a firm to reposition its balance sheet quickly without alerting competitors. The disadvantages of swaps include: Because swaps are agreements, a party who wants to enter into a particular swap must find a counterparty that is willing to take the other side of the swap. Swaps can be illiquid; once entered into, a swap cannot easily be terminated without the consent of the counterparty. Because there are no margin deposits or a clearinghouse that help ensure, or will guarantee, that the agreements will be honoured, the integrity of swaps depends solely upon the financial and moral integrity of the parties that have entered into them. In other words, the swaps have more credit risk than futures contracts. The Demand of Derivatives Based on the statistics of the Bursa Malaysia Derivatives Berhad, the total exchange of derivatives during the year 2009 was up to 6,137,827 contracts. The crude palm oil futures (ETD) is the most liquid future in Malaysia, total of 4,008,882 contracts with average of 334,074 contracts traded monthly during year 2009. (Bursa Malaysia, 2010) Figure 2.1 shows the monthly price traded and the monthly volume of crude palm oil futures (FCPO) traded in Bursa Malaysia from year 1985 until March 2010. The green colour bar represents the price close on the month end was above the open price open on the beginning of the month, while red colour bar indicates the closing price is below the open price. Figure 2.1 indicates that there was less transaction traded during the eighth decade of the 20th century until 2002. The number of FCPO contract traded keep on increasing especially start from year 2002, and is quite popular in recent year, the volume of transaction exceeded 150,000 contracts each month. FCPO is extremely high volume in 2008 because the global oil price is at its peak at USD145 per barrel. FCPO traded at its pinnacle in November 2006 which recorded 360,650 contracts in a month. This showing that the FCPO is high in demand in Malaysia as compare to previous years. Figure 2.2 shows the history chart of FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures (FKLI) traded in Bursa Malaysia from December 1995 until March 2010. There was a high trading volume during the 1997 Asian Financial Crisis due to the high fluctuate of the Kuala Lumpur Composite Index (KLCI). 148,318 future contracts were traded in September 1998. There were at least 40,000 future contracts traded in the following years of 1998. The volume traded increasing rapidly in 2007 as Malaysian economy recovers. KLCI went as high as 1400 points during the last 3 years. 302,321 future contracts were trade in August 2007, which is the highest volume recorded in history. Based on Figure 2.2 trading volume trend, it can be concluded that speculators were heavily involve in trading FKLI in 1997, where the Asian Financial Crisis tragedy occurred and in its peak in 2007 . KLCI fluctuation was elevated during these two event (circled in the chart). For the global market, the market for options developed rapidly in early 80s. The number of option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. According to the Bank for International Settlements, the total OTC derivative outstanding notional amounted to USD605 trillion as of June 2009. Factors That Influence Derivatives Trading Mike Singh (2010) said that trading derivatives will have lesser risk than other trades because investor are not buying into the company or buying the underlying product. Instead, the risk is placed on performance. Due to its low risk factor, investment and commercial banks, end users such as floor traders, corporations, and mutual and hedge funds, are major types of firms that utilize derivatives. A much lower initial investment start up in derivatives trading, derivatives give an edge to those who decline or do not want to invest as much as is required to purchase stock. Derivatives can be a good way to balance ones total portfolio by spreading the risk throughout a variety of investments, rather than putting all eggs into a basket. Besides that, trading derivatives can be a good short term investment. Compared to some stocks and bond, derivatives is an financial instrument that can pay off in a shorter time frame such as days, weeks, or a few months. Stock and bonds are long-term investments and may over the course of many years. As the shorter turnaround time, derivatives can be a good way break into the market and mix short and long-term investments. (Siems, 1997) Numerous resources are available for learning about derivatives trading and many options are available. Hence derivatives are variety and flexibility, this point of view was supported by Mike Singh, 2010. Derivatives can derive profit from changes in equity markets, currency exchange rate, interest rates around the world. It also include the commodities changes in global supply and demand such as precious and industrial metals, agricultural products, and energy products such as petroleum and natural gas. This show that derivatives trading are available on a global scale. Getting involved in the global economy opens international options that may not be available through the traditional stock market. From the points given above, he concluded that there are three reasons for derivatives trading. First, trading derivatives are lesser risk than other trades. Second, trading derivatives are a good short term investment. Third, trading derivatives are variety and flexibility. Hence, derivatives trading may be a good trading option if someone are looking outside of trading traditional stocks and bonds. The International Swaps and Derivatives Association, Inc. (ISDA) announced the results of a survey done on the derivatives usage by the worlds 500 largest companies. According to the survey, 94% of these companies use derivative instruments to hedge and manage their financial risks in business. The foreign exchange derivatives are the most widely used instruments with total 88% of the sample, followed by interest rate derivatives which is 83% and commodity derivatives. There are two benefits which are most widely recognised attributed to derivative instruments, risk management and price discovery. Risk management could be the most vital purpose of the derivatives market. Derivatives also used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect, bearing extra risk by speculations. (Kuhlman, 2009) Price discovery is the prediction of information about future cash market prices through the futures market. There is a relationship between an assets current (spot) price, its futures contract price, and the price that people expect to prevail on the delivery date. By using the information contained in futures prices today, market observers can form estimates of what the price of a given commodity will be at a certain time in the future. Futures markets serve a social purpose by helping people make better estimates of future prices, so that they can make consumption and investment decisions more wisely. (Sorid, n.d) The derivatives market are broadly classified into three uses: Hedging Speculation Arbitrage Hedging Hedging is a way to enter into transactions that expose the entity to risk and uncertainty that fully or partially offsets one or more of the entitys other risks and uncertainties. (Elliot Elliot, 2005) One reason why companies attempt to hedge these price changes is because they are risks that are peripheral to the central business in which they operate. Hedging also refers to managing risk to an extent that makes it bearable. (Kameel, 2008) Equity Hedging Traders can use derivatives to hedge or mitigate risk in the stock market. Entering into a derivative contract can cover part or all of the losses if the value of their underlying position moves in the opposite direction. For equity forward contracts, where the underlying asset is a single stock, a portfolio of stocks, or a stock index, work in much the same manner as other forward contracts. An investor who wishes to sell 100 shares of BAT stock 90 days from now and wishes to avoid the uncertainty about the stock price on that date, could do so by caking a short position in a forward contract covering 100 BAT shares. A dealer might quote a price of RM48 per share, agreeing to pay RM4,800 for the 100 shares 90 days from now. The contract may be deliverable or settled in cash as described above. The stock seller has locked in the selling price of the shares and will get no more if the price (in 90 days) is actually higher, and will get no less it the price actually lower. (Sharma, 2009) For equity future example, an individual stock trader can minimise the stock trading risk by hedging using futures market (Exchange-traded derivatives). A stock trader is extremely aware of economy downturn. If the trader expected an economy downturn is coming which will cause the share price to drop, the trader can protect against down fall of stocks equity by opening a short position of the FTSE Bursa Malaysia KLCI Futures (FKLI) to hedge against his stock portfolio. So if the economy downturn does happen, the trader will gain profit from the FKLI. However, there will be a loss if the trader close the position of the stock during the economy downturn, but the gain from the FKLI will cover some or over the losses from the stock market. Thus, this can reduce the risk by FKLI futures hedging. (Copeland, et al., 2004) For stock option contracts, one call priced at RM6 with a strike price of RM30 gives the holder the right to purchase 100 shares of the stock at RM30 per share until the exercise date. The contract has a money value of RM600 (RM6 x 100 shares). For put options. the concepts are the same, except that the option gives the holder the right to sell 100 shares of the stated stock at RM30 per share through the exercise date. Commodity Hedging Commodity is a physical substance which there is demand, such as basic resources and agricultural. The most popular commodities in Malaysia include CPO, gold, tin, rubber and latex. (Amadeo, 2003) For instance, an airline company which the fuel is the biggest cost item for an airline taken care of, might want to get protection against the fuel price crisis. The airline company might enter into a future contract to hedge the fuel price. They will sign up a future contract with the fuel supplier (OTC derivative), promising that they will buy a certain amount of fuel at a certain price for the next certain months. The contract will definite the price that the airline company to pay for buying the fuel in future. In case the fuel price go higher than the contract price, then the fuel will have a cheaper price. If the fuel price gone down without the airline company expectation, which mean the contract price is higher than the market price, in that incident, the airline company might not want to exercise the contract price. In return, the airline company need to pay certain of fund to the fuel supplier as the contract fee. (Larry, 2005) Malaysian Airline System Berhad (MAS) announced a RM1.34 billion fuel hedge gain in the second quarter ended 30 June 2009. (Francis, 2009) Idris Jala (2009), the Managing Director and Chief Executive Officer of Malaysia Airlines said that he had decided not to unwind the fuel hedges so that the company can remain protected against the volatile fuel prices. MAS had hedged 47% of its fuel requirement at USD103/ bbl WTI for the year ended 2009 from 31 March 2009. Further highlighting the volatility of fuel prices, the fuel price increased 47% since April 2009, those airlines that did not hedge will be affected by the fuel price increasing, said Idris Jala, 2009. While MAS fuel bill increasing in tandem with the fuel price, MAS total fuel bill will be lower as the gains from the fuel hedges will partly offset the higher fuel cost. Foreign exchange (Forex) Hedging In international trading, dealings with forex play a significant role. There will be a significant impact on business decisions and outcomes if got any fluctuations in the forex rate. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Therefore, companies will use forex hedging with forwards, future, option. (Joseph Nathan, 1999) Forex hedging with forwards Forex forward rate is an agreement between two parties (OTC derivatives) to fix the exchange rate for a future transaction. In Malaysia, there are some banks do provide Forward Rate Agreements (FRA) service such as Bank Islam Malaysia, Maybank, EON Bank Group, CIMB Bank Group, HSBC Bank Malaysia, etc. A company simply transfer the risk to the bank when they entering into a FRA with a bank. Of course the bank internally will do some kind of arrangement to manage the risk. (Currencies Direct, 2010) For instance, a Malaysian construction company, Ban Lee Hin Engineering Construction Sdn Bhd just won a contract to build a bridge road in Philippines. The contract is signed for 10,000,000 Peso and would be paid for after the completion of the work. This amount is consistent with Ban Lee Hin minimum revenue of RM750,000 at the exchange rate of RM7.50 per 100 Peso. However, since the exchange rate could fluctuate and end with a possible depreciation of Peso, Ban Lee Hin enters into a forward agreement with Philtrust Bank in Philippines to fix the exchange rate at RM7.50 per 100 Peso. The forward contract is a legal agreement, and therefore constitutes an obligation on both parties. The Philtrust Bank may have to find a counter party for such transaction, either a party who wants to hedge against the appreciation of 10,000,000 Peso expiring at the same time, or a party that wishes to speculate on an increasing the value of Peso. If the Philtrust Bank itself plays the counter party, t hen the risk would be borne by the bank itself. By entering into a forward contract, Ban Lee Hin is guaranteed of an e