Futures, Hedging & Commodity Trading at NCEL ICAP Karachi Thursday, May 13, 2004

1. Futures, Hedging & Commodity Trading at NCEL ICAP Karachi Thursday, May 13, 2004

2. Agenda • Derivatives • Forwards & Futures • Hedging Strategies • Futures Exchange – An antidote to WTO • NCEL • Q&A

3. The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables

4. Examples of Derivatives • Forward Contracts • Futures Contracts • Swaps • Options

5. 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 CCP’s • 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)

6. 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

7. 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

8. 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

9. Foreign Exchange Quotes for GBP/US$ on Aug 16, 2003

10. 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

11. 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

12. 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%

13. Forward Contracts vs Futures Contracts FORWARDS FUTURES Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Range of delivery dates Settled at maturity Settled daily Delivery or final cash Contract usually closed out settlement usually occurs prior to maturity

14. 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)

15. 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

16. Basis Terminology Gold spot Rs 7,200 November Futures Rs 7,220 Basis - Rs 20 Nov The basis is “20 under November”

17. Basis Terminology Gold spot Rs 7,200 November Futures Rs 7,180 Basis Rs 20 Nov The basis is “20 over November”

18. 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.

19. 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.

20. Convergence of Futures to Spot Basis = Sp – Fp B < 0 B > 0 FP SP FP SP Time Time (a) (b)

21. 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)?

22. 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

23. 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?

24. 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

25. 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.

26. 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

27. 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

28. 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 levelthe next day • Spot month margins will be required in the delivery month • Delivery margin, which could be as high as 25%

29. 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.

30. Value-at-Risk

31. Gold Prices

32. Sigma = 2 VaR @ 99%

33. Sigma = 4 VaR @ 99%

34. 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)

35. A Possible Outcome Daily Cumulative Margin Futures Gain Gain Account Margin Price (Loss) (Loss) Balance Call Day (US$) (US$) (US$) (US$) (US$) 400.00 4,000 5-Jun 397.00 (600) (600) 3,400 0 . . . . . . . . . . . . . . . . . . 13-Jun 393.30 (420) (1,340) 2,660 1,340 4,000 + = . . . . . . . . . . . . . . . . . 3,000 < 19-Jun 387.00 (1,140) (2,600) 2,740 1,260 4,000 + = . . . . . . . . . . . . . . . . . . 26-Jun 392.30 260 (1,540) 5,060 0

36. Futures Market

37. 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

38. How Do Derivative Contracts Improve Market Operations? • 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

39. "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

40. 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

41. 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

42. Wheat Price Comparison between Major & Minor Pakistani Markets(For Three Years) Sowing Sowing Harvesting Sowing Harvesting Harvesting Red = Average of Three Major Markets Yellow = Average of 9 minor Markets 2000-01 2001-02 2002-03 Source: Federal Bureau of Statistics

43. Hedging

44. 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

45. 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

46. 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

47. 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.

48. 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

49. 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

50. Yarn – Price Correlation