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Literature Review On Malaysian Demand For Derivatives Investment

Chapter 2: Literature Review

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 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)

The above chart showing the volume of crude palm oil futures (FCPO) traded in Bursa Malaysia from March 2007 until Feb 2010. The FCPO traded at its peak on April 2009 which recorded 442,220 contracts in a month. Showing that the FCPO is high demanding in Malaysia in recently year.

F:\CHLow Data\Documents\CW\1Disst\2_LReview\FKLImth2.jpg

The above diagram is showing the FTSE Bursa Malaysia KLCI Futures (FKLI) chart. It showed that the volume was less during the year 2000 until year 2003. Then the futures transaction keep increasing. It was recorded 302,993 contracts had been traded on the month of August 2007. It remain high volume for the following years.

2.1 Factor 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 on the performance. Due to its low risk factor, banks include investment banks and commercial banks, end users such as floor traders, corporations, and mutual and hedge funds, are main types of firms that use derivatives.

A much lower initial investment start up in derivatives trading, derivatives give advantages 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 add balance to ones total portfolio, it 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. (Singh, M., 2010) Compare 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.

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. (Singh, M., 2010)

From the above points by Mike Singh, 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) today announced the results of a survey of derivatives usage by the world's 500 largest companies. According to the survey, 94% of these companies use derivative instruments to manage and hedge their business and financial risks. The survey found that foreign exchange derivatives are the most widely used instruments (88 percent of the sample), followed by interest rate derivatives (83 percent) and commodity derivatives.

There are two benefits which is most widely recognised attributed to derivative instruments, risk management and price discovery. (Kuhlman, B., 2009) Risk management could be the most vital purpose of the derivatives market. Derivatives altering the latter to equal the former by identifying the desired level of risk, and identifying the actual level of risk. 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, B., 2009)

2.1.1 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 entity’s other risks and uncertainties. (Elliot, B. and Elliot, J., 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, A., 2008)

2.1.1.1 Equity hedging

Traders can use derivatives to hedge or mitigate risk in the stock market, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.

For instance, 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.

2.1.1.2 Commodity hedging

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.

Malaysian Airline System Berhad (MAS) announced a RM1.34 billion fuel hedge gain in the second quarter ended 30 June 2009. (Francis, I., 2009) Idris Jala, 2009, 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. (Francis, I., 2009)

2.1.1.3 Foreign exchange hedging

In international trading, dealings with foreign exchange play a significant role. There will be a significant impact on business decisions and outcomes if got any fluctuations in the foreign exchange 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 foreign exchange hedging with forwards, future, option. (Kameel, A., 2008)

Foreign exchange hedging with forwards

Foreign exchange forward rate is a 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. (Kameel, A., 2008)

For instance, assuming that 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, then the risk would be borne by the bank itself. By entering into a forward contract, Ban Lee Hin is guaranteed of an exchange rate of RM7.50 per 100 Peso in the future no matter of what happens to the spot rate of Peso. If Peso were to actually depreciate, Ban Lee Hin would be protected. However, if it were to appreciate, then Ban Lee Hin would have to forego this favourable movement and hence bear some implied losses. Even though this favourable movement is still a potential loss, Ban Lee Hin proceeds with the hedging since it knows an exchange rate of RM7.50 per 100 Peso is consistent with a profitable venture. (Kameel, A., 2008)

Foreign exchange hedging with futures

The futures hedging eventually overcome some of the shortcomings of the forward hedging. Both futures contract and forward contract are almost similar, but forward contract is much more liquid because it is traded in an organised exchange trading market - the futures market, which is ETD derivatives. It is similar with buying shares in the stock market where standardised contracts are bought and sold. The futures contract is also a legal contract just like the forward, but the obligation can be eliminate before the expiry of the contract by making an opposite transaction. For futures hedging, the trader needs to buy futures contract if the trader expect there will be appreciation of the currency value, or the trader needs to sell futures contract if the trader expect there will be depreciation of the currency value. (Kameel, A., 2008)

Consider the earlier bridge road constructing in Philippines example, beside forwards, Ban Lee Hin could involve in futures hedging by selling Peso futures to hedge against Peso depreciation. Assuming Ban Lee Hin now hedge against Peso currency by selling Peso futures at RM7.50 per 100 Peso, which the contract size amounting to RM750,000. On the payment day after the completion of work, the Peso rate go against the interest of Ban Lee Hin and dropped in value to RM7.20 per 100 Peso. Ban Lee Hin would then close the futures contract by buying back the contract at this new spot rate - RM7.20 per 100 Peso. Ban Lee Hin gain a future profit of RM30,000 for the contract which bought from RM7.20 per 100 Peso and sold it for RM7.50 per 100 Peso. However, in the spot market Ban Lee Hin gets only RM720,000 when it exchanges the 10,000,000 Peso contract value at RM7.20 per 100 Peso. Eventually, the total cash flow is RM750,00 as well which derive from RM720,000 from spot exchange rate and RM30,000 profit from futures contract.

One of the advantage of using futures hedging is the Ban Lee Hin can release itself from the futures obligation by buying back the contract anytime before the expiry of the contract. A trader needs to pay a deposit called an initial margin to enter into a futures contract. The trader would receive a margin call (also known as variation margin), requiring him to pay up the losses whenever his account makes a loss for the day when the losses hit certain percentage of the initial margin. (Kameel, A., 2008)

Advantages of futures hedging

Liquid and central market - since futures is Exchange-traded derivatives (ETD), trader who has taken a position in the futures market can easily close position at any time.

Leverage - futures have a margin system, where a trader 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 a one percent change in the futures price which is RM1,000, would bring about a 10 percent change relative to the trader’s initial costs.

Disadvantages of futures hedging

Initial and daily variation margins - the futures position is tracked on a daily basis, the trader would be required to pay up daily variation margins if got any daily losses. The initial and daily variation margins can cause some cash flow burden on traders.

Forego favourable movements - any profits or losses in the spot transaction would be offset by losses or profits from the futures transaction.

Foreign exchange hedging with options

Option is a more flexible instrument than futures. Foreign exchange option is a contract between two parties (OTC derivative) which is the buyer and the seller. The seller of the option needs to be compensated by paying the premium of the option, for giving the right to buyer to buy (call options) or sell (put options) a specified currency at a specified exchange rate, at or before a specified date. (Hong Leong Bank Malaysia, 2010)

For instance, a trader buys a January RM7.50 Peso call option for RM0.30. Therefore, the trader has the right to buy Peso for RM7.50 per 100 Peso before the contract expired in January. the RM0.30 that paid is the premium for this right, also known as strike price or the exercise price. If the Peso appreciates over RM7.50 per 100 Peso within the expired date, then the trader may exercise his right and buy it for RM7.50 per 100 Peso. If the Peso were to depreciate below RM7.50 per 100 Peso, then the trader may just let the contract expire without taking any action since he is not obligated to buy it at RM7.50 per 100 Peso. I the trader needs physical Peso while the rate depreciate, he may just buy it in the spot market at the new lower rate.

Consider again the earlier bridge road constructing in Philippines example, since the risk of Ban Lee Hin is the depreciation of Peso, Ban Lee Hin would need to buy put options in Peso. If Peso were to actually depreciate by the time Ban Lee Hin receives the revenue in Peso, then Ban Lee Hin would exercise its right and exchange its Peso at the higher exercise rate. However, if Peso were to appreciate instead, Ban Lee Hin would just let the contract expire and exchange its Peso in the spot market for the higher exchange rate. Therefore the options hedging allows traders to enjoy unlimited favourable movements while limiting losses. Unlike the forward or futures contracts where the trader has to forego favourable movements and there is also no limit to losses.

Advantages of options hedging

Limited risk - option had unlimited favourable movements, the loss is up to the whole premium paid.

Flexibility - there is neither initial margin nor daily variation margin since the position is not marked to market. This could potentially provide significant cash flow relief to traders.

Disadvantages of options hedging

Expensive - Because options are much more flexible compared to forwards or futures, hence the price is the disadvantage.

The options market is simply an organised insurance market. One pays a premium to protect oneself from potential losses while allowing one to enjoy potential benefits. For instance, when one buys a car insurance, one pays its insurance premium. If the car gets into an accident, one gets compensated by the insurance company for the losses incurred. However, if no accident happens, one loses the premium paid. If no accident happens but the car value appreciates in the second hand market, then one gets to enjoy the upward trend in price. An options market plays a similar role. In the case of options however the seller of a option plays the role of the insurance company.

According to the derivatives usage survey 2009 done by International Swaps and Derivatives Association (ISDA), Malaysian company Petronas rank 95th of the usage of derivatives. Petrolnas is actively involved in foreign exchange derivatives.

Sachi Ratnajoothy mention in the Star Business, 2009, saying that foreign exchange (forex) hedge is also an instrument that helps to mitigate the impact of the currency market volatility. Such foreign exchange contracts usually attract companies involved in international trade and require huge amount of foreign currencies for the business. Lee Kok Kwan told the Star Business that by hedging foreign exchange risks, businesses and individuals could lock in one’s cost or preserve one’s margin of future forex receipts or payments in current ringgit terms.

2.1.1.4 Interest Rate Hedging

Interest rate swap hedging

Interest rate swap (IRS) is the exchange of one set of cash flows (based on interest rate specifications) for another. IRS is an agreement between two parties, but occasionally involves more than two, is a type of OTC derivatives. The intention of IRS is to standardised to the requirement of interest rate of the parties involved. IRS can be used by hedgers to manage their fixed or floating assets and liabilities. It also use to hedge against future rise or fall in interest rates. (Maybank, 2008)

The three main types of IRS are:

Fixed-for-fixed swaps - interest rate swaping of both parties with the fixed rates determined before the IRS contract takes effect. Different currency usually involve by each party when Fixed-for-fixed swaps are used (Parsani, V., 2009)

Fixed-for-floating, or "vanilla" swaps - interest rate swaping involve the exchange of a fixed interest payment for a floating interest payment. This is commonly use as a type of investment. The fixed rate payment, also known as the swap rate does not change since it is fixed, while the floating rate payment is linked to several outside index, such as the London Interbank Offered Rate (LIBOR) and goes up and down throughout the period of the contract.F:\CHLow Data\Documents\CW\1Disst\2_LReview\Vanillaswap.png

Firm A has a floating rate loan from a lender. Firm A thinks that the floating interest rates will rise and hopes to avoid higher payments. Firm A entering IRS hedging by paying a fixed rate to Firm B. Firm B receives a fixed payment from Firm A and pays it a variable payment (floating rate) in return, which Firm A then pays to its lender. In this case, Firm B do so because probably thinks that floating rates will fall. If favourable movement goes to Firm B which the floating falling, Firm B will pay out less than the fixed amount it receives from Firm A, making a profit off the difference. (Parsani, V., 2009)

Floating-for-floating swaps - interest rate swaping of both parties have floating interest payments rates involved. The floating rates are based on different indexes, so each party is betting that their own original floating rate will raise and the opposite party original floating rate will fall, making a profit off the difference. (Parsani, V., 2009)

Interest rate option hedging

Interest Rates Option (IRO) gives the trader the right but not the obligation, to fix the interest rate on a future loan or deposit, for a pre-determined amount which starts on an agreed future date. It also mean to give the trader a right, but not obligation to lock in a predetermined fixed rate. A premium cost is payable upfront. (RHB Banking Group, 2009)

Interest rate hedging are not regulated by any government agency, the traders have a great deal of flexibility when setting the terms of the hedging. In Malaysia, there are several commercial banks that provide interst rate hedging service such as Hong Leong Bank, CIMB Bank, Maybank, OCBC Bank Malaysia, etc. Globally, the total notional amount of interest rate swaps outstanding was USD437 trillion as of June 2009, accounting for 72% of the total OTC market. (BIS, 2009)

Yeow Pooi Ling, 2009, wrote in the Star Business mention that there are more demand for interest rate swaps from corporate clients given the present low interest rate environment. IRS is useful a tool for businesses with long-term non-fixed rate loans to transfer the interest rate risk to the financial markets via intermediaries such as banks. Sachi Ratnajoothy said that IRS enables businesses to better manage their liability profiles without altering the underlying loans.

By utilising IRS and foreign exchange hedging products, business owners could limit their risk exposure while having the peace of mind to focus on growing the business as those risks were transferred to intermediaries like banks. The IRS and forex hedging could become a disadvantage to companies, depending on the direction of the interest rate and currencies, they offered a form of certainty in terms of cash flow management. (Gan. KK., 2009)

Lee Kok Kwan, 2009, mention in the Star Business that companies and individuals should focus on how much losses or reduced revenue they can stomach in ringgit terms from their overseas sales, or escalation in costs from imports, or from rising interest rate cost on floating rate loans.

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