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CHAPTER 2: CONCEPT OF DERIVATIVE - Coggle Diagram
CHAPTER 2: CONCEPT OF DERIVATIVE
Definition
Financial instruments whose value is derived from its underlying assets.
Financial instrument whose value depends on or derives from values of other assets.
Major Participants
Hedgers
Physical owners of the underlying commodity who will use derivative instruments to protect their risk exposure in the cash market
The economic function of derivatives market to provide hedging mechanism for hedgers
Hedgers will use derivative market as a forum for managing unfavorable price movements
Speculators
Traders who are attracted to the market in view of profiting from the volatility of prices
Justifiable because they have to assume the price risk that hedgers seek to avoid.
Exposed to high risk in view of their position as long-term traders who normally hold derivative contracts for more than one week.
Arbitrage
Types of derivative
Future
Contract between buyer and seller to buy or sell underlying instrument at specific price today and time in future
Need a third parties to act as clearing house for both parties
Low default risk, commission regulated and guaranteed by clearing house
Option
Contract that give right to one party and obligation to the other parties to buy or sell underlying asset at agreed price at specific time period
Low default risk and had legal requirement of margin payment
Forward
Contract between buyer and seller to buy and sell a specific security at a specified price in the future on maturity date
Basically known as private negotiable agreement
High default risk, self regulated and had no guarantee of performance
Swap
Usually happen between two countries due to the need of international business
Had a similar trading procedure to forward as they are not regulated
Purpose
Price Discovery
The willingness of futures markets to disclose information on future cash market values
By pointing to the derivative price now, investors will readily discover the probable price in the future
Hedging Mechanism
Futures market players use derivative contracts as a proxy for cash market trades
The physical owners of a product use derivative instruments to routinely control their price costs
Origin & Growth
Origanated formally from foward transactions :
1st organized futures trading took place in Japan in the 18th century
Trading was organized because merchants would buy these tickets based on their future needs of rice
The existence of the organized futures market were reinforced by the introduction of the date of delivery
Structure & Development
Structure
Ministry of Finance: controller
Securities Commission: regulator
BMDB: operator of exchange
BMDC: clearing house
Development
M'sian derivative market today: have single derivative exchange (BMDB), with single clearing house(MDCH) & sole regulator (SC) for all derivatives trade
2005
: MDEX now known as BMDB and MDCH as BMDC
Mar'02
: MDEX launched 1st bond futures contract based in ringgit on the MGS
May'01
: KLOFFE & COMMEX merged to form single derivative market, MDEX
Dec'98
: KLCE & MME merged to form COMMEX
May'96
: KLIBOR launched at MME
Dec'95
: M'sia became 1st nation outside Japan to trade local-based index with the trading of KLCI futures at KLOFFE
1991
: named 1st South-East Asian multi-commodities futures
Thereafter, KLCE trades other national agro-based commodities(tin&cocoa)
OCT1980
: M'sia join derivative trading (launch of CPO futures traded at KLCE)
Exchange-Traded vs Over-the-Counter
Over-the-Counter
Market place: not centralized
Self-regulated
Trading: negotiated contract
Not transparent
Margins payment: no legal requirement
Credit/default risk: high
No guarantee of performance
Exchange-Trade
Market place: centralized
Commission-regulated
Trading: standardized contract
Transparent
Margins payment: legal requirement
Credit/default risk: low
Guaranteed by clearinghouse