In finance, a derivative is taken as a financial instrument that possesses value based on the underlying asset’s expected future price movements. Financial instrument, in other words, is simply an agreement between two parties, while underlying asset is an asset to which a derivative is linked. Underlying assets can be in form of share or currency. Currently, there are many kinds of derivatives, and the most commonly seen types are swaps, futures, and options. Derivatives are seen as a form of alternative investment.

A derivative cannot be treated as a stand-alone asset because it has no value itself. Nevertheless, trading of common types of derivatives have been done on market as if they were assets before expiration. Rice futures are among the earliest of these. Their trading on the Dojima Rice Exchange started since the 18th century.

Categorization of derivatives can be done on the following basis:

The link between the underlying asset and the derivative, for example forward, option, or swap.

The kind of underlying asset, for instance, equity derivatives, commodity derivatives or credit derivatives.

The market in which the derivatives are traded such as exchange-traded or over-the-counter.

The pay-off profile of derivatives.

Also, there is a distinction between:

Vanilla derivatives (simple and more common).

Exotic derivatives (more complicated and specialized). [1 ]

How Derivatives Work?

To visualize how derivative investment works, it is best to utilize a comprehensible example. Consider a commodity derivative which is linked to rice as its underlying asset. Farmer X who is in a rice plantation industry goes into a derivative contract with an agriculture businessman Y. According to the contract, farmer X agreed to sell rice to businessman Y on a future date concurred by both parties. The selling price based on the agreement is for instance, RM 100 per kg, which is the current market price. After the agreement is set, the execution of contract can be done.

When time reaches the fixed future date and rice is ready to be traded, but unfortunately the market price of rice has dropped to RM 50 per kg. All other farmers will suffer from tremendous losses but not farmer X. Businessman Y had agreed to purchase his product at the price of RM 100 per kg which is higher than the current market price of RM 50 per kg. On the other hand, businessman Y will now make losses because he has to buy the product at a price higher than the market price.

Consider another scenario that the market price of rice has gone up to RM 150 per kg when the fixed future date comes. Farmer X is now the one who loses money because he agreed to sell his product to business Y at a price lower than the current market price (RM 100 per kg), whereas businessman Y is making higher profit because he is buying rice at a cheaper price. [2 ]

Trading of Derivatives in Malaysia

In Malaysia, derivatives tradings are maintained by the Bursa Malaysia Derivatives Berhad (BMD). Bursa Malaysia Derivatives Berhad, previously recognized as Malaysia Derivatives Exchange Berhad (MDEX), is a subsidiary of Bursa Malaysia Berhad that offers, runs and maintains a futures and options exchange. BMD runs the most liquid and flourishing crude palm oil futures (FCPO) contract worldwide.

In September 2009, Bursa Malaysia Berhad and Chicago Mercantile Exchange started a strategic partnership with the view to extend the accessibility to Malaysia’s derivatives offerings worldwide. This enables licensing of the settlement prices of the FCPO to place Malaysia as the global price benchmark for the commodity. It also opened the opportunity for distribution of Bursa Malaysia’s products globally through the Globex electronic trading platform. 25% of the equity stake in BMD is currently owned by CME, while the remaining 75% interest is owned by Bursa Malaysia Berhad.

Three Major Types of Derivatives in Malaysia

Commodity Derivatives

In commodity derivatives, as the name indicates, the underlying is a commodity such as gold, wheat, machinery and so on. Initially, commodity derivatives were intended to provide protection to farmers so that to reduce the risk of under or over-production of crops. Being a financial instrument for traders who traded in the underlying commodity previously, commodity derivatives are currently a risk management tool. They are now traded in the market most often by traders who do not need for the commodity itself. In other words, they never actually possess the commodities, but they keep trading them in the market. The available products under this group are as follows:

Crude Palm Oil Futures (FCPO)

USD Crude Palm Oil Futures (FUPO)

Crude Palm Kernel Oil Futures (FPKO)

Equity Derivatives

An equity derivative is a category of derivatives whose value is at least partially derived from one or more underlying equity securities. Options and futures are the most common equity derivatives so far. Nevertheless, there are many other types of equity derivatives that are aggressively traded. Equity derivatives available in Malaysia are:

FTSE Bursa Malaysia KLCI Futures (FKLI)

FTSE Bursa Malaysia KLCI Options (OKLI)

Single Stock Futures (SSFs)

Financial Derivatives

A financial instrument whose characteristics and value depend upon the characteristics and value of an underlying asset. This category consists of interest rate derivative and government securities futures. Currently, there are three products being categorized by BMD under this group, namely:

3 Month Kuala Lumpur Interbank Offered Rate Futures (FKB3)

3-Year Malaysian Government Securities Futures (FMG3)

5-Year Malaysian Government Securities Futures (FMG5)

Risk and Return

To understand risk management of using derivative contracts, the expected return/risk relation must first be figured out. Referring to the following figure, the expected return is represented by the vertical axis while the horizontal axis represents risk. Derivatives risk management actually deals with going along the line by entering particular derivative contract positions.

Consider a farmer who is planting wheat. The point C on the figure might represent, for instance, the farmer’s current unhedged, expected return/risk profile. The coordinates of point C may be determined by assessment of the mean and the variance of the wheat price distribution. The farmer’s decision about what to do depends on his risk preferences. If desired, the farmer can engage in a lower-risk strategy by committing to deliver part of his anticipated crop of wheat at a price that is fixed today. This short forward commitment would bring his return/risk profile toward the risk-free rate of return, to point B for example, and would be referred to as hedging. Hedging is a technique that attempts to reduce risk and derivative can be used as a form of insurance in hedging.

On the other hand, if the farmer is confident that wheat prices are going to rise because of poor weather during the rainy season and thus the low yield, he may not hedge. He should keep his risk profile at point C, or he may attempt to profit from his directional view regarding wheat price movements and buy forward to increase his risk profile from C to point D for instance.

There are different types of risk to be managed and it should be made clear that risk management is however synonymous with return/risk management. In equilibrium, one cannot be moved without moving the other. [3 ]

Figure: Expected return/risk tradeoff (Adopted from Derivatives: Markets, Valuation, and Risk Management, by Robert E. Whaley)

Advantages and Drawbacks

Advantages

1. Lower risk than other trades

When trading in derivatives, it is not the underlying asset or the company to be bought in, although in futures trading, there is an agreement stating that the purchase of the product is to be done in the future. Losing money in derivatives trading is still possible but the risk is much lesser than other investments. Furthermore, if a trader does not want to invest as much as required to purchase stock, the trader can involve in derivatives trading for a much lower initial investment. Derivatives can act as balance to a trader’s total portfolio, spreading the risk to a variety of investments instead of only a few.

2. Derivatives can be used as short-term investment

If a trader is looking for an investment that is able to pay off in a comparatively shorter time frame, he or she should consider derivatives. Some stocks and bonds are invested on a long-term basis, whereas derivatives can pay off within days, weeks, or several months. Due to the shorter turnaround time, derivatives can be a proper way to break into market and also a suitable way to blend short-term and long-term investments. If a trader has a portfolio comprising of long-term investments like stocks and bonds, derivatives may be a good choice to put the money to work at once. To make derivatives work, detailed research and consideration is essential. Traders in a fast-paced world have the option to see results in derivatives trading that are unavailable through other means mush sooner.

3. High variety and flexible

Derivatives traders get more involvement and have better handle on what and where their money is working. Some derivatives trading options were made available around the clock globally. This is a factor that draws investors to derivatives investment. Involving in the global economy is fascinating for some people and it creates international options that may not be found through the traditional stock market.

Drawbacks

1. Possible huge losses

Usage of derivatives may result in tremendous losses because of leverage and borrowing. Derivatives enable traders to make big return from small underlying asset’s price movements. Nevertheless, traders might make huge losses if the asset’s price movement does not favor them significantly. For instance, Barings Bank lost equivalence of $1.2 billion from equity derivatives investment in the year 1995.

2. Counter-party risk

Counter-party risk is the risk to each party of a contract that the counter-party will not live up to its contractual obligations. Counter-party risk as a risk to both parties and should be considered when evaluating a contract. [4 ]

Consider two independent parties, Joe and Mike for instance. Because Joe is a counter-party to Mike and at the same time Mike is a counterparty to Joe so both of them are exposed to this risk. There is a risk that either one of the two parties will not fulfill as agreed in the contract.

3. Huge notional value

Derivatives basically have a huge notional value. Therefore, there is a risk that usage of them could lead to losses that wouldn’t be compensated by the trader. Possibly, this could result in a chain reaction that further leads to economic crisis. The previous statement is made based on well-known investor Warren Buffett’s opinion in Berkshire Hathaway’s annual report (2002). He addressed them as “financial weapons of mass destruction”. Derivatives control a gradually growing notional amount of assets. Distortions in the real capital and equities markets might follow the phenomena. What was initially intended to transfer risk becomes a leading indicator because traders now look to the derivatives market when making decisions in trading.

4. Leverage of an economy’s debt

Derivatives seriously leverage the debt in an economy, making it ever harder for the underlying real economy to service its debt obligations, thereby limiting real economic activity, which can cause a recession or even depression.

Performances of Derivatives in Malaysia [5 ]