Futures, Hedging

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
• QA

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 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)

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
Bid Offer
Spot 1.4452 1.4456
1-month forward 1.4435 1.4440
3-month forward 1.4402 1.4407
6-month forward 1.4353 1.4359
12-month forward 1.4262 1.4268
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 _at_ US300/oz. in December
  (COMEX)
• sell 62,500 _at_ 1.5000 US/ in March (CME)
• sell 1,000 bbl. of oil _at_ US20/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 lt 0
B gt 0
FP
SP
FP
SP
Time
Time
(a)
(b)
21
Gold An Arbitrage Opportunity?

• Suppose that
• The spot price of gold is US300
• The 1-year forward price of gold is US340
• 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 (1r )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(10.05) 315

23
Oil An Arbitrage Opportunity?

• Suppose that
• The spot price of oil is US19
• The quoted 1-year futures price of oil is US25
• 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 level the 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 _at_ 99
33
Sigma 4 VaR _at_ 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 US400
• margin requirement is US2,000/contract (US4,000
  in total)
• maintenance margin is US1,500/contract (US3,000
  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
lt
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
51
NCEL An antidote to WTO
52
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

53
Price Trend
54
Cotton Prices
55
Cotton Prices
56
Exchange Rates
57
Percentage Change of Average Monthly Yarn prices
of 21/1
2000-01
2001-02
2002-03
2003-04
58
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

59
NCEL
60
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

61
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

62
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

63
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
64
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
65
NCEL Business Process
Accepted Orders
Cancelled/Expired Orders
Cancelled/Expired Orders
On a daily basis
Each matched order has a buyer and a seller
Warehouses
Clearing Banks
66
Contract Development
Seed Cotton
Textiles Process
Ginning
Lint Cotton
Weaving
Spinning
Apparel Garments
Yarn
Processing
Knitting
Syn. Fibre
67
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
68
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!

69
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

70
Financing Mechanism
Entire profits go to the farmer if NGO manages
price risk using NCEL
Farmers
Middleman
Middleman effectively eliminated from process
Crop
Cash Seeds Other inputs
NGO views futures prices at NCEL and enters into
a contract
Warehouse Receipt
NGO
NCEL
Cash
71
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

72
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

73
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

74
Order Trade Confirmation Process
75
Classification of Risk

• Credit Risk
• Liquidity Risk
• Settlement Risk
• Market Risk
• Operational Risk
• Legal Risk

76
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

77
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

78
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

79
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

80
Market Surveillance Contd

• To identify situations that could pose a
  threat to manipulation and to initiate preventive
  action by monitoring
• Large traders
• Key price relationships
• Supply and demand factors
• Spot market activities

81
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

82
Thank You