Contracts in a Derivative Market

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B. Literature Review

2.1 Forward Contract in derivative market

Forward contract is a non-standardized contract, while requiring at least two parties (buyer and seller) participated in the underlying asset. The contract price was negotiated under the agreement between both parties. In the agreement, the price agreed on today with the delivery of an asset at a given future date. Forward contract does not require any cost to enter this market. In addition, forward contracts comprise two different positions in the market; there are both long and short positions. Long position is a party that has agreed to buy the underlying asset, while short positions are a party that has agreed to sell the underlying asset.

Forward contracts are traded through under over the counter (OTC). Forward contract traded in over the counter does not have any requirement, as long as agreement is made by both parties (Duffie, Gârleanu, Pedersen, 2005). For instance, buyers and sellers negotiated the price on underlying asset privately. The buyers and sellers do not understand clearly the price is negotiated the in market due to limited knowledge of trades. Therefore, they will ignorance prices currently available from other potential counterparties. At present, most investors to make a trade through the telephone or internet network that associated with the OTC market. For example negotiated agreements arise when the supplier expects to produce 10,000 tonnes of crude palm oil within 9 months. At the same time, buyers should assume that require 10,000 tons of crude palm oil is also within 9 months. It reflects the short position (sellers) have promises to make deliveries, while long positions (buyers) have promises to take. They used to use forward contracts to hedge against commodity, foreign exchange and financial demands. The features of the forward contract can attractive to investor or corporate who interested to lock in profit and to minimize the risk of the certain underlying assets.

In addition, Sill (1997) pointed that speculators will get some advantages by using forward contracts to speculate and to engage in arbitrage activities. Speculators are traders who take a position in the derivatives market by utilize few contract to generate the higher- than –average risk in return for a higher- than- average profit potential. Normally, speculators betting that the price of the underlying assets will move in a certain direction throughout the duration of the contract at the same times they will deal with higher risk. For instance, speculator who believes that the value of the commodity in market will raise in the future, so speculator will take as a long position to buy in a forward contract on the certain commodity (Sill, 1997). If the value of the commodity on the maturity date is above the price are agreed to lock on today, this points that speculator already generate the return from this trading. Besides, Meera (2002) mentions that the business results and the profit will be affected by fluctuations in price of the underlying asset.

Besides, the investor would step into forward contract agreement that would protect them from price risk (Taylor, Dhuyvetter & Kastens, 2003). Cooperation or investor used the forward contract to lock the price to avoid fluctuations of the products. There must comply with the agreement between the buyer and seller. In usual of this agreement both party will face the price risk (Taylor et al., 2003). Both parties does not have the ability to expect accurate the movement of price would go, in the form of increase or decrease in the price Actually, both sides have their own concept of mind in terms of the price at which the transaction will be done in the maturity date. In a conclusion, the forward contracts consider as a hedging strategy that able to help the both parties eliminate price risk of the certain underlying asset. These types ofinvestors try to avoid huge changes in the price and are satisfied with a stable income for the suppliers.

There have some common drawback and risk while using forward contract, such as counterparty risk and default risk (John, 2011). Counterparty and default risk refers to the possibility that one of the parties unable to make a payment to the transaction. The change in spot price considered as a one issue influence default risk arise. For example, if spot prices of underlying assets started to decline, the buyer start to face losses since he has agreed to a forward price based on the higher previous spot price. On the other hand, if spot prices rise, the seller start to face losses since underlying assets can be sold at a higher forward price whereas he has agreed to a lower forward price. Seller would regret against his decision by locked the prices at the lower forward price.

2.2 Future Contract in derivative market

Futures contract refer to an agreement to buy or sell an asset at a certain time for a certain price (John, 2011). There are two assets that available traded in future contract which are financial assets such as stock, bond and currency and commodity assets like oil and gold. In future contract, the buyer and seller are negotiated indirectly, which is traded through exchange market. Future contract is a standardized contract because everything is fixed and cannot be negotiated. There is no default risk for future contract since that the default risk is borne by clearinghouse which guarantees the transactions for buyer and seller. Clearinghouse will help to manage the risk by marking-to-market and margins in future contract.

Form the journal we studied, Bacha (1999) had examines the related of derivative instrument and Islamic banking instrument. The paper focus to analyze in futures, forward and options contract and discuss the benefit and advantages for hedging instrument and hedging strategy in Islamic finance. First, use the forwardt and future contract in derivative market can help the party to eliminate price risk. The party who implement forward and future contract will only pay the agreed price regardless the spot price in future because the parties have to lock the price previously. Besides, the different between forward and futures contract is futures contract can be standardized with respect to quality, contract maturity, contract size and others. To standardization it’s to increases liquidity of the contract, reduces transaction costs and solves the problem of double coincidence of wants (Bacha, 1999).

In additional, Islamic finance instrument for financial derivative such as Ba’i Salam, that is a transaction between two parties agree to implement business transactions due to underlying of the asset in future date of agreement. In a Salam sale, buyer has to pay full amount at the maturity time based on the contract. The objective of Ba’i Salam is a ‘prepayment’ requirement and for purpose to help small firm and poor famers with working capital financing. Salam sale is focusing more of the beneficial to the seller and set price normally is lower than the market price. Besides that, Istijrar contract recently introduced in Islamic financial derivative instrument, the contract has entrenched options that might be caused if the underlying asset price more than certain bound. For Istijrar transaction, company are normally seeking for short term working capital and purchase business material such as raw material, the bank will purchases the material at current price and after that sells the material back to these company. The company will make payment based on mutually agreed within both parties (Bacha, 1999).

Based on the journal of “Hedging Foreign Exchange Risk with Forwards, Futures, Options and the Gold Dinar: A Comparison Note” is stated about the hedging strategy for foreign exchange risk through derivatives instrument. In this journal, the author is focusing about the advantages and disadvantages by using forward and future contract. Futures market normally can used to solve the deficiency of the forward market. However, there also having some disadvantages by using future strategy. First of all, according to Meera (2002), futures contract are very liquidity because it are traded in central market and easily to make transaction due to central market. A trader who hold the future contract can easily make the transaction prior of the maturity but forward contract need wait until the maturity day only can do transaction. Besides, the leverage of future contract is better than forward because future contract claim a small initial deposit compare to forward. Future contract leverage are allows the holder to hedge large amount with a smaller outlay.

However, the disadvantages of the futures contract are about the legal obligation. Legal obligation is one of the restrictions for business community when implement futures contract as hedging tools. For instance, the futures position becomes a speculative position when hedging in futures that the bidding process unsuccessful. Furthermore, it is difficult to come out with the perfect hedging because future contract have its own standardized features such as expire date, contract size and some of the spot transactions will not be hedged (Meera, 2002).

From the studied of “Dynamic vs. Static Stock Index Futures Hedging: A Case Study for Malaysia”, authors found that stock index futures become more popular for hedging strategy and they also stated that there are some of the pros of futures hedging. According to Ford, Pok & Poshakwale (2005), the stock index futures contracts provided an opportunity in order to handle the market risk of the portfolios and a fund manager can selling stock index futures contract in order to hedge the falling in the value of the portfolio. Profit gained will remunerate the falling in the value of portfolios; this can help to saving the trouble of adjusting the portfolio. Authors also stated that possibility of using leverage to create the speculative gains is one of the advantages in stock index futures hedging. To trading for a large amount of the stocks, investors are required small amount of investment for trading. Besides that, the standard features of stock index futures contract also allow the transactions can be completed ahead of schedule. With the electronic transaction, trading sessions can allow the investors to get the positions within a few minutes.

Other than that, investors also can sell their futures contract easily because the contracts do not have the significant difference in the amount that required for buying or selling the contract. According to Ford, Pok & Poshakwale (2005), they also found that futures contract not only can used to hedge the potential risk effectively, it also can provide low transaction costs compare with trading equities costs. Introduce the stock futures index is useful for Malaysia because it expanded the range of risk management strategies and investment for stock-selection strategy and portfolio management.

2.3 Swap Contract in derivative market

Swap is one of the interest rate risk management instrument that able to assists contractor to adjust or hedge against the interest rate variation in the market. Swap is a contractual agreement between two parties to exchange cash flow according to certain specified rules for a set of maturities in the future time. The very first swap contract was introduced in the market in the early 1980s (Kuprianov, 1994). Swap normally used by companies and countries to hedge against the risk that may occur beyond estimation such as interest rate risk, exchange risk and etc. The most common swap that actively in market is the interest rate swap. According to Skar (2004), Interest rate swap is the contracts that enable counterparties to exchange interest rate payment based on agreement for a fixed period of time. The process of swap is explained diagrammatically in Figure 1. Swap typically used to exchange fixed interest rate with floating interest rate or vice versa between both parties according to agreement in specific and continues future date. For example, Party A paid fixed rate 8% to Party B and received floating rate (LIBOR) from Party B. This process will continues for specific future date in order to help both party hedges against the interest rate risk.

Figure 1 : Swap Process

Toyoshima (2012) stated that different hedging instrument has the various maturity times. Most hedger prefers using swap because its maturity time is longer than other financial instrument. By this longer period, hedger can be far protected from the interest rate variation in market compare with others financial instrument (Sundar, 2012). Malaysia is one of the countries that offer this kind of swap known as MYR interest rate swap, which has the characteristic of ten years tenors with MYR 30 million size of amount (Davies, Hillier & Marshall, 2004).

In additional, swap may hedge against interest rate fluctuation with the lower cost. The issuer using swap to reduce cost of funding in the short-term interest rates declining stage by converting fixed rate payment obligation to floating rate payments (Skar, 2004). However, it consider to have a risk pegged with the swap, it may be possible to receive lower fixed rate by issuing floating rate bonds and at the same time goes into fixed rate swap agreement than would achieved by issuing fixed rates bonds (Skar 2004). Sundar (2012) stated that, issuer always enters into the swap market by using their comparative advantage in order to reduce their cost of funding.

According to Skarr (2004), there have some common drawback and risk while using swap, such as counterparty risk and termination risk and etc. Counterparty risk is the risk that the counterparty unable or unwilling to accomplish its obligation of the swap contract. This risk occurred when the counterparty is defaulted and unable to make the payment according to the agreement. Hence, issuer would losses the payment from the counterparty. However, this risk can be eliminate and minimize through construct a set of rating level requirement, guideline for exposure levels and collateral requirement (Skarr, 2004). The best ways to mitigate the risk is entering into swap contract only with ratings of AA and above.

Besides, termination risk means the swap agreement has a possibility to terminate by counterparty prior to the expectation date. This risk happened when counterparty is default or dissatisfy against the term and condition of swap contract that entered. In order to prevent counterparty make an early quit or terminate in the swap contract, termination payment has to be establish and stated in the swap agreement. The termination payment should be base on the market value of the differences between current rates and the agree swap rate for the remaining time of the swap maturity (Skarr, 2004). Even so, there would still have a probability of termination risk to be happened. However, counterparty would be more secured with the termination payment that received from the party that terminates the contracts.