Presentation on theme: "Futures, Hedging & Commodity Trading at NCEL ICAP Karachi Thursday, May 13, 2004."— Presentation transcript:
Futures, Hedging & Commodity Trading at NCEL ICAP Karachi Thursday, May 13, 2004
Agenda Derivatives Forwards & Futures Hedging Strategies Futures Exchange – An antidote to WTO NCEL Q&A
The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables
Examples of Derivatives Forward Contracts Futures Contracts Swaps Options
Derivatives Markets Exchange traded –Traditionally exchanges have used the open- outcry system, but increasingly they are switching to electronic trading –Contracts are standard –There is virtually no credit risk as exchanges are CCPs Over-the-counter (OTC) –A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers –Contracts can be non-standard and –There is credit risk (counterparty risk)
Ways Derivatives are Used To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another
Forward Contracts A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery price) It can be contrasted with a spot contract which is an agreement to buy or sell immediately It is traded in the OTC market
Forward Price The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today The forward price may be different for contracts of different maturities
Foreign Exchange Quotes for GBP/US$ on Aug 16, 2003 BidOffer Spot1.44521.4456 1-month forward1.44351.4440 3-month forward1.44021.4407 6-month forward1.43531.4359 12-month forward1.42621.4268
Example On August 16, 2001 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.4359 This obligates the corporation to pay $1,435,900 for £1 million on February 16, 2002
Futures Contracts Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange Virtually no credit risk as the exchange is a CCP
Other Key Points About Futures Standardized contract Quality is pre-defined and permissible variation is settled through premium or discount Requires a margin prior to taking a position They are settled daily – marked to market Variation margin is payable in cash only Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity – 98%
Forward Contracts vs Futures Contracts Private contract between 2 partiesExchange traded Non-standard contractStandard contract Usually 1 specified delivery dateRange of delivery dates Settled at maturitySettled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDSFUTURES
Examples of Futures Contracts Agreement to: –buy 100 oz. of gold @ US$300/oz. in December (COMEX) –sell £62,500 @ 1.5000 US$/£ in March (CME) –sell 1,000 bbl. of oil @ US$20/bbl. in April (NYMEX)
What Determines Basis ? As basis reflects local market conditions it is directly influenced by several factors such as : Interest / Storage Costs Transportation costs Local supply and demand conditions Handling Costs
Basis Terminology Gold spot Rs 7,200 November Futures Rs 7,220 Basis - Rs 20 Nov The basis is 20 under November
Basis Terminology Gold spot Rs 7,200 November Futures Rs 7,180 Basis Rs 20 Nov The basis is 20 over November
Strengthening Basis If the spot price increases relative to the futures price, or the difference between the spot price and futures price becomes less negative (or more positive). A strengthening basis works to a sellers advantage.
Weakening Basis If the spot price decreases relative to the futures price, or the difference between the spot price and futures price becomes more negative (or less positive). A weakening basis works to a buyers advantage.
Convergence of Futures to Spot Time (a)(b) FPFP S P Basis = S p – F p B < 0 B > 0 SPSP F P
Gold: An Arbitrage Opportunity? Suppose that: -The spot price of gold is US$300 -The 1-year forward price of gold is US$340 -The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity? (We ignore storage costs)?
The Forward Price of Gold If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then F = S (1+ r ) T where r is the 1-year (domestic currency) risk- free rate of interest. In our examples, S = 300, T = 1, and r =0.05 so that F = 300(1+0.05) = 315
Oil: An Arbitrage Opportunity? Suppose that: -The spot price of oil is US$19 -The quoted 1-year futures price of oil is US$25 -The 1-year US$ interest rate is 5% per annum -The storage costs of oil are 2% per annum Is there an arbitrage opportunity ?
Delivery If a contract is not closed out before maturity, it usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash
Delivery Instruments Vault Receipts are used for the delivery of precious metals and certain financial instruments. E.g. Gold Warehouse Receipts are used with delivery of grain. E.g. Wheat Demand Certificates are used with delivery of perishables.
Margins A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
How Margins Work ? An initial margin must be deposited at the time the contract is entered Margin account is marked to market on a daily basis i.e. adjusted to reflect the investors gain or loss – direct debit The investor is entitled to withdraw any balance in the margin account in excess of the initial margin – in case of NCEL we will pay only if requested
How Margins Work ? To ensure a certain minimum balance in margin account a maintenance margin is set. If margin account balance falls below the maintenance margin, the investor receives a margin call and is expected to top up the account to the initial margin level the next day Spot month margins will be required in the delivery month Delivery margin, which could be as high as 25%
How Margins are Determined ? Initial margin is based on a scientific risk management methodology called Value at Risk (VaR) VaR is a method of assessing risk that uses standard statistical techniques routinely used in other technical fields. Methodologies such as variance/covariance, EWMA, historical simulation, etc. Formally, VaR measures the worst expected loss over a given time interval under normal market conditions at a given confidence level Exchanges use SPAN, TIMS, PRISM, etc.
Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 –contract size is 100 oz. –futures price is US$400 –margin requirement is US$2,000/contract (US$4,000 in total) –maintenance margin is US$1,500/contract (US$3,000 in total)
Futures Exchange Contracts are standardized Trading is centralized Market-making is competitive Third-party guarantee of contract performance Do not have to borrow or own underlying to short sell Trading is certificateless Low transaction costs
Aid in price discovery and serve as a reference point –Participants attracted to markets –Additional resources spent on information collection and analysis –Arbitrage between markets transmits the new information throughout the complex of markets How Do Derivative Contracts Improve Market Operations?
"Forward Looking" Prices Futures prices are estimates of future cash prices Price basing refers to the practice of using futures prices as a base or reference point for other transactions
Do Futures Stabilize Cash Prices? Investment is encouraged because of low transaction costs Investors are likely to drive prices to levels justified by economic fundamentals Volatility in futures and options prices transmitted to cash by arbitrage Removes distortions and fragmentation
How Do Derivative Contracts Improve Market Operations? Facilitate the exchange of risk across market participants –A commercial risk is transferred to someone more willing to bear the risk –Exchange-traded futures facilitate trade between strangers –May improve the liquidity of underlying cash markets
Wheat Price Comparison between Major & Minor Pakistani Markets (For Three Years) Source: Federal Bureau of Statistics Red = Average of Three Major Markets Yellow = Average of 9 minor Markets Sowing Harvesting Sowing 2000-012001-022002-03
Types of Traders Hedgers Investors Arbitrageurs Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators
Long & Short Hedges A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price
Arguments in Favor of Hedging Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables
Choice of Contract Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price.
Hedging Strategy to reduce risk of future price volatility e.g., suppose you (a garment manufacturer) signed a contract to sell jeans over 1 year at a fixed price –options: buy all denim cloth requirements now –need storage space; have to incur carrying cost buy yarn futures contracts with delivery dates spread out through out the year
Hedging Examples A garment exporter will receive $1 million for exports to the US in 3 months and decides to hedge using a short position in a forward contract A yarn manufacturer imports machinery for $1 million for which payment will be made in 6 months will use long position in a forward contract
Textiles - End of Quotas! Sudden drop in protection after 50 years Production and market share is unfrozen Quota holding is no longer passport to Western Markets Market share will be gained through international competitiveness More players leads to falling prices There is always someone cheaper Hedging platform is a necessity for the value added textile sector
Percentage Change of Average Monthly Yarn prices of 21/1 2000-012001-022002-032003-04
NCEL: An Antidote to WTO Platform for hedging – lock in prices Will allow manufacturers to manage raw materials price-risk – in case of textile related industries it is as high as 80% Exporters can enter into longer term contracts Less chances of reneging on contracts Overall, has a smoothening effect on prices Positive impact on employment and poverty alleviation
Background NCEL established on April 20, 2002 Permission granted by SECP on May 16, 2002 Present Shareholders –KSE-40% –LSE-10% –ISE-10% –Pak Kuwait Investment Co. – 10% –Zarai Taraqiati Bank Ltd. – 10% Paid-up-Capital Rs.40 million (post ZTB) Additional FI participation (20%) being considered Authorized Capital Rs.50 million
Highlights First de-mutualized exchange in Pakistan First fully integrated electronic exchange capable of also handling financial futures First to employ modern risk management techniques – Value-at-Risk First to introduce the concept of The Central Counterparty First to introduce Vault Receipts and Warehouse Receipts – negotiable instruments First to develop a Spot Yield Curve for the market
Key Drivers for Success Provide a transparent platform for easy and equal access for all participants Trading Regulations will provide complete confidence and protection to investors and users Risk Management, and Surveillance & Monitoring will be based on the international Best Practices Developing thoroughly researched contract specifications
Target Market GDP - Rs4,042 billion (2002-03) Agriculture contributes 24 % - Rs970 billion Share of major crops 9.6% - Rs388 billion Textiles represent 10.5% - Rs424 billion Crude oil & oil products imports - Rs156 billion Palm oil imports - Rs26 billion Internationally the multiple for cash versus futures is 5-70 times
Vision/Mission FROM Price distortions Wide spreads or one way quotes Absence of standardization Counterparty risk Impediments in financing Price manipulation TO Observable future prices Narrow spreads and two way quotes Quality certification & standardization Risk mitigation Ease in financing Price dissemination To provide an opportunity to the farmers to farm for the market
Warehouses Clearing Banks Accepted Orders Cancelled/Expired Orders NCEL Business Process On a daily basis Each matched order has a buyer and a seller
Contract Development Syn. Fibre Weaving Knitting Processing Spinning Apparel & Garments Ginning Seed Cotton Lint Cotton Yarn Textiles Process
Price Trend of Pakistani Wheat (For Three Cropping Seasons) Sowing Period Harvesting Period Source: Federal Bureau of Statistics *Prices are the Average of 12 Pakistani Markets
Agriculture Sector Tenant farmers do not have access to organized financial sector Borrows from unorganized sector at rates as high as 120% per annum Forced to sell immediately upon harvest – no holding power Compromise on inputs – low yield per acre Lack of infrastructure – warehousing Middleman provides a one stop shop!
Commodity Based Financing Structured form of financing with an objective of transferring risk from an entity to a commodity In discussion with a NGO to undertake financing as a pilot project on the following basis : 1. Pre-sowing for inputs against NCEL contract (short) and social collateral 2. Post-harvest and upon storage against a warehouse receipt
Farmers NGO NCEL Entire profits go to the farmer if NGO manages price risk using NCEL Middleman effectively eliminated from process Financing Mechanism Middleman NGO views futures prices at NCEL and enters into a contract Cash Seeds Other inputs Crop Cash Warehouse Receipt
360° Company Update Hardware and software has been installed Software is being configured Gold and Cotton Yarn contract specifications are being developed Regulations are being refined and have to be approved by the Board and SECP 95% hiring is complete Online bank transfer arrangements are being finalized with MCB
360° Company Update Contd…. Vault arrangements are being finalized with KASB Bank Ltd. Mock trading will begin by 24/5/04 ZCYC, Cotton Farmers & Ginners ROI, Wheat Farmers ROI, etc. White Papers are being prepared and will be presented, shortly Rice and Wheat contracts are being developed for next season
360° Company Update Contd…. Staff is highly educated and experienced in trading futures, risk management, IT, investment banking, agriculture, textiles, financial mathematics, corporate & securities law, stock-broking, accounting, tax, etc…… Go Live when Members are ready
Risk Mitigation Strategies Clearing Limits – Members Position limits – Members & Clients Initial & Maintenance Margins Variation Margin – daily MTM Additional Margin in the spot month to ensure convergence Standard NCEL approved documentation
Risk Mitigation Strategies Contd… Security Deposit Clearing Limit – Members Initial Margin – Members & Clients Pre-Trade Check Segregation Bank Accounts – Members & Clients Sub-accounts at CDC Mark-to-market daily settlement - online Position Limits – to counter manipulation
Margining Example - Gold –Clearing Deposit: Rs1.5 million = 4% –Initial Margin: Rs0.5 million = 4% Initial Margin: 99% VaR over 1 day Spot Month Margin: 99% VaR over 10 days Delivery Margin: 99% VaR over 3 days
Market Surveillance Apart from legal requirements, NCEL will demonstrate self-regulatory presence as it is just good business practice …. We must win confidence of participants and demonstrate that there is integrity in our market Must protect investors in our marketplace
Market Surveillance Contd… To identify situations that could pose a threat to manipulation and to initiate preventive action by monitoring: a.Large traders b.Key price relationships c.Supply and demand factors d.Spot market activities
Zero Coupon Yield Curve (ZCYC) Also known as the Spot Yield Curve NCEL will use ZCYC for calculating theoretical futures price ZCYC can be used to price wide range of securities including coupon paying bonds, derivatives, FRAs and swaps NCEL is estimating ZCYC using primary market data for Government securities Can also be used to price non-sovereign fixed income instruments after adding in credit spreads