an investor’s guide to extended settlement contracts · 2012-02-11 · an investor’s guide to...

An Investor’s Guide to Extended Settlement Contracts

This document provides information of a general nature only. Neither this document nor any information or opinion herein constitutes an offer, solicitation or invitation to make an offer to buy or sell any securities or any options, futures or other derivatives related to securities or any other financial instrument ("financial instruments"). Recommendations for any investment product in this document are intended for general circulation and do not take into account the specific investment objectives, financial situation or particular needs of any particular person. Investors should seek advice from a professional financial adviser before investing in any financial instruments or adopting any investment strategies discussed in this document.

Examples used in this document are for illustrative purposes only and do not constitute investment advice. The value or price of, or income from, any financial instruments referred to in this document may fluctuate and may be affected by changes in exchange rates. Accordingly, investors may receive an amount that is less than the amount originally invested, or may lose the entire principal amount invested. Past performance is not necessarily a guide to future performance. Any investments discussed herein may involve significant risk, may be illiquid and may not be suitable for all investors.

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In the event that the circulation of this document constitutes provision of financial advisory services, please note that SGX is an exempt financial adviser under the Singapore Financial Advisers Act (“FAA”) and is exempt from certain provisions of the FAA, when providing financial advisory services to accredited and/or expert investors, and overseas investors, as provided for under Regulation 35 and 36 of the Singapore Financial Advisers (Amendment) Regulations 2005, respectively.

This booklet explains the general characteristics and risks of Extended Settlement (ES) contracts traded on the Singapore Exchange (“SGX”).

Investors should read the contents carefully to understand the nature and risks of Extended Settlement contracts. Investors should assess the suitability of Extended Settlement contracts in meeting their investment objectives and risk profiles. Information on Extended Settlement is available from your broker and on SGX website at www.sgx.com.

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Chapter 1

Introduction

An Extended Settlement (ES) contract is a contract between two parties, to buy or sell (a) a specific quantity (e.g. 1,000 shares) of (b) a specific security (e.g. SIA) at (c) a specific price (e.g. $15.00) for final settlement at (d) a specific future date (i.e. when the contract matures or expires).

ES contracts are listed and traded on the Singapore Exchange (SGX-ST). You can buy and sell ES contracts the same way you buy and sell shares through your stockbroker.

However, ES contracts are classified as futures contracts under the Securities and Futures Act (“SFA”). Before you trade ES contracts for the first time with your broker, you must sign a Risk Disclosure Statement (see more information in Chapter 3). In addition, when you buy or sell an ES contract, you must put up margins.

CONTRACT SPECIFICATIONS

Contract Specifications Description

Trading Platform

Underlying Securities

Margin Requirements

Board Lot Size

Minimum Tick Size

Contract Months

First Trading Day

Last Trading Day (LTD)

Settlement Day

Settlement Basis

Trading Hours

Currency

Naming Convention (Trading name)

SGX Quest ST

SGX-ST listed securities

Prescribed by SGX

Standard board lot

As per underlying market

Spot Month

25th of the month that is immediately preceding the contract month i.e. A Feb 09 ES contract will start trading on 25 January 2009.

Last market day of the contract month (“market day” is a day on which the SGX-ST is open for trading in securities)

3rd market day after LTD (LTD + 3)

Physical settlement

ES trading hours will be in line with the trading hours of the underlying securities in the ready market.

As per underlying market (SGD only in phase 1)

<underlying security>.ES.<YYMM> e.g., ABC.ES.0810 = ABC Extended Settlement, contract month October 08

For more details on ES Contract Specifications, please refer to the SGX website at www.sgx.com.

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Underlying Securities

Each ES contract is based on a single underlying security (e.g. a XYZ ES contract is based on XYZ shares). The underlying securities of ES contracts are traded on SGX’s securities trading platform, SGX-ST.

Not all securities listed on SGX-ST will have corresponding ES contracts offered for listing and trading. The criteria for stock selection include trading volume and market capitalization. SGX will conduct periodic reviews on the list of selected securities to take into account relevant market conditions.

If the need arises, SGX may remove any ES contract from quotation before the LTD if all positions in such ES contract have been offset. If there are positions in such ES contract that are not offset, SGX may require that such positions be cash settled immediately according to the terms prescribed by SGX-ST, or restrict trading only to enable those positions to be offset.

Contract Months

ES contracts will commence trading on the 25th of the month that is immediately preceding the spot month and cease trading on the last market day of the spot month. Each ES series will, therefore, have a tenure of approximately 35 days. There is a consistent overlap period for customers to ‘roll over’ their positions in ES contracts. This is shown in Figure 1 below:

Figure 1

As shown in Figure 1, an investor can ‘roll over’ his position in the XYZ Mar 09 ES contract by entering into an offsetting trade in the XYZ Mar 09 ES contract and initiating a new position in the XYZ Apr 09 ES contract concurrently during the period that the two contracts overlap, i.e. from 25 March 09 to 31 March 09.

Trade Settlement

Settlement of ES contracts takes place by way of delivery of the underlying securities on the third market after the Last Trading Day (“LTD + 3”). On LTD + 3, ES contracts are settled in the same manner as ready market trades. Payment and receipt of the purchase and sale consideration, respectively, will take place in accordance with the current practice of the ready market.

If the seller of the ES contract does not have any or sufficient underlying securities of the ES contract on LTD + 3 to meet delivery obligations, CDP will conduct buying-in of the underlying securities to close off the outstanding position. The current procedures for buying-in under the CDP Clearing Rules will apply.

Similarly, if an investor does not pay for underlying shares which have been delivered for a buy ES contract, the broker can force-sell these shares to recover the cost paid by the broker.

Default Management

In the event that your broker defaults, the CDP will not step into the shoes of your broker to settle your broker’s obligations under your ES contracts with you. This is the standard practice in the futures market and applies both before and after the Last Trading Day of ES contracts. This is different from current ready market trades where, in the event that your broker defaults, the CDP will settle trades that are due after the default with you.

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25/2/09 31/3/09

XYZ Mar 09 (XYZ ES.0903)

25/3/09 30/4/09

XYZ Apr 09 (XYZ ES.0904)

Overlapping period of 5 days

Trading Hours

The trading hours for ES contracts will follow the trading hours for the ready market. The trading hours for ready market full day trading are as follows:

Session Timing

Pre-Open

Non-Cancel

Open

Adjust

Non-Cancel

Open

Pre-Close

Non-Cancel

Closed

0830 - 0859

0859 - 0900

0900 - 1230

1230 - 1359

1359 - 1400

1400 - 1700

1700 - 1705

1705 - 1706

After 1706

The trading hours for ready market half day trading are as follows:

Session Timing

Pre-Open

Non-Cancel

Open

Pre-Close

Non-Cancel

Closed

0830 - 0859

0859 - 0900

0900 - 1230

1230 - 1235

1235 - 1236

After 1236

4

Corporate Actions

Where the underlying security of the ES contract is the subject matter of any corporate action, SGX may adjust the ES contract accordingly. The decision to make any adjustment will be in accordance with guidelines which SGX will publish. SGX may decide, for example, where the corporate action is widely anticipated (for instance, dividend payout) and has a relatively small impact on the underlying, not to make an adjustment.

It is important for investors to note that SGX will be introducing methods of corporate actions adjustments to ES contracts in phases. Please refer to the webpage at www.sgx.com/es for updates and details on the Phase 1 and 2 of corporate action adjustments to ES contracts.

At launch (Phase 1), depending on the nature of the corporate action in respect of the underlying, SGX may bring forward the LTD of the ES contract. In such cases, the ES contract expires early and the LTD is brought forward to the market day before the ex date for the corporate action. The ES contract will be settled into the underlying on the Book Closure Date (BCD). The buyer of the ES contract will receive the underlying securities on the BCD, and consequently also the relevant entitlement(s) resulting from the corporate action. Where early expiration occurs for an ES contract, SGX may also list a new ES contract with an obligation to deliver or take delivery of the underlying on an ex basis, to replace the expired ES contract.

In Phase 2, in addition to the possibility of bringing the LTD forward, SGX may make one or more of the following adjustments to the ES contract:

(a) amend the quantity of underlying security to be delivered and the price of the ES contract (for example, an issue of bonus shares, stock split);

(b) amend the price of the ES contract (for example, a special cash dividend);

(c) amend the underlying securities to be delivered (for example, if the underlying is subject to a merger and acquisition); and

(d) where applicable, amend the contract on such other terms as the relevant ES Contract Specifications provide.

[See Appendix 1 for examples of adjustment for corporate actions in Phases 1 and 2].

As far as practicable, SGX will give prior notice of such adjustments and the effective date.

Clearing Fees and GST

An investor will pay the same fees for trading shares and ES contracts. The following fees are chargeable:

• Brokeragefeesleviedbybrokers

• Clearingfeeof0.04%onthevalueofthecontract,subjecttoamaximumofS$600;and

• PrevailingGoodsandServicestax(GST)onbrokerageandclearingfees.

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Chapter 2

Benefits of Trading Extended Settlement Contracts

ES contracts are flexible instruments that offer you numerous advantages including:

i) Capital Efficiency

When you enter into an ES contract, you only have to put up a small initial deposit or margin instead of the full contract value or price of the underlying security to secure the trade. This allows you to maximize the efficiency of your capital since a small amount of capital will enable you to gain exposure to a larger amount of securities and allows you to trade multiple times exposure. As compared to margin financing which provides 3 times leverage, ES contracts can provide you with higher leverage ranging mostly from 5 times to 20 times depending on the volatility of the security.

ii) Ease of Taking Short Positions

Short selling refers to the selling of a security that a seller does not own, so that the seller may be able to profit by buying the security at a lower price later.

If you hold a bearish view of the market, ES contracts will allow you to gain from downward movements of stock prices by taking short positions. The transactional costs are greatly reduced as compared to borrowing shares for gaining a short exposure unless you hold your position until settlement.

iii) Longer view of market

ES contracts provide you with more than one month to offset your positions. In comparison to the ready market, this will allow you to take a longer view of the market.

Risks of Trading Extended Settlement Contract

i) Leveraged Nature of ES Contracts

As in most investments, trading in ES contracts can lead to losses for investors if the price in the underlying security moves against you. ES being a leveraged product, the losses suffered from trading ES contracts will be greater in percentage terms of the initial cost or capital outlay needed to enter into an ES position i.e. your margin deposit, against the price movement in the underlying asset.

Trading a contract value several times larger than the margins deposited means that the risks and returns are similarly magnified accordingly, as opposed to a same amount of capital placed for a position directly in the underlying.

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Forexample,iftheinitialmarginrequiredforaparticularEScontractis10%ofthatEScontractvalue,thenthe leverage is 10 times and the risk and return is magnified 10 times as shown below:

Loss

Quantity

Purchase Price

Contract Value

InitialMargin(Assume10%)

Closing Price

Profit/(Loss)#

%ChangeagainstContractValue

%ChangeagainstMarginDeposited

Profit or Loss Leverage

1,000

$10.00

$10,000

$1,000

$9.90

(-$0.10 x 1,000) = ($100)

1%(100/10000)

10%(100/1000)

10 Times

Profit

1,000

$10.00

$10,000

$1,000

$10.10

($0.10 x 1,000) = $100

1%(100/10000)

10%(100/1000)

10 Times

# cost of funds are not taken into consideration

ii) Margin Calls

An investor may sustain a total loss of the funds placed for initial margin and any additional funds deposited to maintain a position in the ES contract. If the market moves against the investor or margin levels are increased, the investor may be required by his broker to pay additional funds on short notice to maintain the position. If the investor fails to comply with a request for additional funds within the specified time, the broker may liquidate the position and the investor will be liable for any resulting deficit in his account. The potential loss from trading ES contracts is therefore not limited to and can be several times the initial margin paid originally to support the position.

iii) Liquidity

Similar to ordinary shares in the ready market, there is no assurance that a liquid market will always exist for an ES contract. An illiquid market could occur if there are few willing buyers and/or sellers for the ES contract. This may increase the risk of loss by making it difficult or impossible for an investor to liquidate a position in the ES contract.

Two useful indicators of liquidity are the volume of trading and the open interest of the contract (the number of ES positions still remaining to be liquidated by an offsetting trade or satisfied by delivery). These figures are published on the SGX website.

In addition to an illiquid market, the ability of an investor to liquidate his ES position may be affected by the operation of certain rules, e.g. the suspension of trading in any ES contract or the underlying due to unusual trading activity or news events involving the issuer of the underlying security.

iv) Volatility

Because the stock market can be volatile at times, the prices of ES contracts are similarly affected. You must be aware of the impact of volatility on risk and return.

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v) Buying-In

If you hold a short ES position until expiration, you have an obligation to physically deliver the underlying security for settlement. If you do not have the required securities in your account on the settlement day (the third market day following the Last Trading Day), CDP will buy-in shares on your behalf to satisfy your delivery obligation. You are required to pay for the bought-in securities and any associated costs.

Buying-in starts the day after the settlement day (LTD + 4), and will start at a minimum of two bids above the highest of the closing price of the previous day, the reference transacted price or the reference bid price.

vi) Risks and Safeguards of Customer Margins Deposited with CDP by Brokers

Under the Securities and Futures Act (“SFA”), each broker is required to segregate customers’ margins for ES trades from its own house monies. The broker will place the required amount of customers’ margins and brokers’ house margins with CDP, which will maintain the segregation of customers’ margins from house margins.

A broker may not use the funds of one customer to meet the margin requirement of another customer. The broker must calculate its daily segregation requirements and utilize its own funds to cover any customer defi cits.

Effect on non-defaulting customers in event of default by another customerIn the event a broker fails to meet its obligations to CDP as a result of a default by one of its customers, CDP has the authority to use margins from the broker’s other non-defaulting customers placed with CDP to meet the broker’s outstanding obligations to CDP. A customer may hence, not be able to recover the full amount of funds in his/her account if the broker becomes insolvent and has insuffi cient funds to cover its obligations to all of its customers.

Effect on non-defaulting customers in event of default by brokerHowever, if a broker fails to meet obligations to CDP and this failure is not a result of a default by one of its customers, customers’ margins placed with CDP will not be used by CDP to meet the broker’s outstanding obligations.

Comparison of Extended Settlement Contracts, Contra and Margin Financing

Contra trading

Leverage

Financing cost

Short selling

Borrowing cost

Infi nite leverage

< 3 days, no fi nancing cost> 3 days, Cash tie-up

Intra short selling

N.A.

Margin fi nancing

Shares 2x leverage Cash 3x leverage

> 3 days, Financing costs kick in

No short selling

Reverse margin (SBL) involves borrowing cost

ES contracts

5x to 20x leverage

<≈ 35 days no fi nancing cost>≈ 35 days Low opportunity cost on cash (margins only)

Taking short positions up to the tenure of the contract

No borrowing costs

• Trading Account

The trading account allows you to transact shares and ES contracts on the Singapore Exchange. If you do not have a trading account, you may approach any broking house which holds the requisite CMS futures license to open an account. (The reference to the list of brokers has been removed pending the approval of futures licenses)

• CDP Securities Account

A securities account holds all the securities you buy on SGX, and records the movement of the shares in and out of your account as you buy and sell them electronically. To open a securities account, you can visit CDP at the following address:

ADDRESS: 4 Shenton Way, #02-01 SGX Centre 2, Singapore 068807

TEL: (65) 6535 7511

FAX: (65) 6535 0775

EMAIL: [email protected]

WEBSITE: www.cdp.com.sg

Alternatively, the broker with whom you are opening a trading account can also assist you in opening a securities account at the same time.

• Sub-Accounts

At launch and for the duration of Phase 1, the use of sub-accounts linked to settlement on a Delivery-vs-Payment (DVP) basis will not be available.

ii) Risk Disclosure Statement

Before trading in ES contracts, investors are required to sign a separate Risk Disclosure Statement (RDS) with their brokers. An example of an RDS may be found in Appendix 3.

iii) Statements

• Contract Statements

On the market day after an ES trade has been executed, the broker will send out a contract statement to the investor to confi rm the trades which the investor has entered into on the previous day.

• Statement of Account

At the end of every month, the broker will send the investor a statement of account. This statement of account will show the investor’s outstanding positions with the stockbroker as at the end of the month.

• CDP Statement

Investors will receive a monthly CDP statement from SGX to refl ect the overall shareholdings the investor has in his account if the investor has outstanding long or short positions which expired into physical settlement during the month. In the event that no transactions are made, the CDP statement will be sent to investors on a semi-annual basis.

• Reporting Requirements

Investors and directors of listed companies must take note that transactions in ES contracts will amount to a change of interest in the underlying security. Investors should take note, in particular, of the reporting requirements imposed by section 7(6), Division 4 of Part IV and Division 2 of Part V of the Companies Act (especially sections 164-166).

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Chapter 3

Getting Started

i) Accounts

Buying and selling ES contracts is similar to buying and selling shares. Before you can start investing in shares or ES contracts, you need to have two accounts: a trading account with a stockbroker and a securities account maintained directly or indirectly with The Central Depository Pte Ltd (CDP).

Chapter 4

Margins and Collateral

i) Margins

You are required to put up margins for both long and short positions when you execute an ES contract. As long as your ES contract remains outstanding, you must meet ongoing margin requirements.

• Initial Margins (IM)

IM refers to the minimum amount of margin you are required to deposit with a broker for opening positions in ES contracts.

SGX will prescribe different levels of margin requirements for ES contracts based on the underlying securities. Outright and spread margins will mostly be set in fixed tiers depending on the volatility of the underlying.

Forexample,foranEScontractonthesharesofcompanyX,SGXmayprescribea10%marginrequirement.This means that for an ES contract to buy or sell 1000 company X shares priced at $1 each, the margin requirement is $100.

Your broker may collect more margin than the margin rates specified by SGX for risk management purposes.

• Maintenance Margins (MM)

MM refers to the margin which must be maintained in your account subsequent to the deposit of IM for your outstanding positions in ES contracts. The IM required needs to be at least equal to MM, and the broker may require IM margins that are higher than MM.

• Variation Margins (VM)

VM refers to the mark-to-market gains and losses, in relation to the price at which the ES contract was bought or sold, arising from the daily valuation of the ES position. VM is computed daily based on outstanding contract and Valuation Price as determined by SGX, up to and including Settlement Day, i.e. LTD + 3.

A net loss increases the Variation Margins and Required Margins amount, and a net profit decreases the Variation Margins and Required Margins amount.

• Required Margins

This is the total amount of margins you are required to maintain for your outstanding ES contracts.

ii) Daily Mark-to-Market

At the end of each day, all outstanding ES contracts will be revalued or marked to their respective Valuation Prices by the CDP. This daily revaluation is called ‘Mark-to-Market’ (MTM).

The Valuation Price represents the official price of ES contracts prescribed by SGX for the purpose of calculating the mark-to-market losses or gains.

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Required Margins = Maintenance Margins + Variation Margins

• Treatment of Profits and Loss

If marking-to-market or offsetting positions result in profit, you can withdraw the excess margins. Alternatively, you can use the excess margins as collateral for new positions.

If marking-to-market or offsetting positions result in loss, you are expected to top up additional margins. The available margin holding in your account with your broker may serve as progressive payment towards the final settlement obligations.

• Margin Calculation

Example of outright margining:

Initial Margin (IM)(assume margin rate = 10% & underlying price = Valuation Price)

Investor A buys 1 lot of XYZ ES at $10.00

Valuation Price is $9.50

($10.00x1,000) x10%=$1,000

($9.50x1,000) x10%=$950

Variation Margin(VM)

($10.00 - $9.50) x 1,000 = - $500 (Loss adds to margin requirement)

Required Margins =MM+VM

$950 + $500 $1,450

Example of spread margining:

When an investor holds both a long and a short position in ES contracts of different contract months of the same underlying security, the investor will only need to put up spread margins instead of two maintenance margin amounts (one for the long ES position and one for the short ES position).

Note – this example does not take into consideration the cost of funds

Valuation Price of ES

Investor A buys 1 lot of Nov XYZ ES at $10.00

Investor A sells 1 lot of Dec XYZ ES at $10.10

$10.20

$10.40

Maintenance Margin (MM)

(assume spread rate = 2.5%

& underlying price = $10)

($10.00 - $10.20) x 1,000 = - $200(Profit reduces margin requirement)

- ($10.10 - $10.40) x 1,000 = $300

Variation Margin (VM)

$250 – $200 + $300 $350

Required Margins =MM + VM

($10.00 x 1,000x2.5%=$250


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iii) Margins for Positions which have been Offset

All trades, including trades that offset an existing position (i.e. long and short positions on the same ES), will only be settled by CDP on the third market day after the Last Trading Day (LTD + 3). Accordingly, Variation Margins will be collected from investors for all trades.However, positions which have been offset will, under normal conditions, not require Initial Margins and Maintenance Margins.

Example

Investor A makes a profit of $400 from buying and selling XYZ ES contracts. The investor can use this profit to put up as margin for the next trade. For instance, investor A decides to purchase 5 lots of PQR ES contracts, requiring him to put up a margin of $1,000. Instead of putting up $1,000, investor A can use the profits from trading of XYZ ES contract to offset. Therefore, he/she will only need to top up $600.

Valuation Price


Investor A sells 1 lot of XYZ ES at $10.40

Investor A buys 5 lots of PQR ES at $2.00

$10.20

$2.00


(assume margin rate = 10% &

underlying price = Valuation Price)

- $400

- $400 +$0- $400

Variation Margin(VM)

MM+VM

$0

($2x5,000)x10%= $1,000


iv) Margin Calls

If the assets or funds you have lodged with your broker fall below the sum of Maintenance Margin and Variation Margin, the broker must call for additional margins from you to top up the difference. An investor must top up the shortfall in margins, up to the level of Initial Margin and Variation Margin, within 2 market days.

Example

In the following example, the required margin when the valuation price is $9.50, is $1,450. Since the margin holding of the investor is $1,200, the investor will receive a margin call. However, the investor has to top up to the level of Initial Margin + Variation Margin, which adds up to $1,640. Therefore the margin call amount would be $440 ($1,640 - $1,200).

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($10.00 - $9.50) x 1,000 = $500

($10.00 - $10.20) x 1,000 = - $200


$950+ $500$1,450

$1,020 - $200 $820

Required Margin

= MM+VM

$950 x 1.2 = $1,140

$1,020 x 1.2 = $1,224

Initial Margin (IM) (assume

1.2MM)

($9.50x1,000)x10%=$950

($10.20x1,000)x10%=$1,020

IM+VM Margin Holding (assume prompt

payment)

Margin Call

$1,140 + $500$1,640

$1,224 - $200 $1,024

$1,200

$1,640

$440

$0


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v) Excess Margins

When the asset you have lodged with your broker is more than the sum of Initial Margin and Variation Margin, you can withdraw the difference.

Example

Using the same illustration above, when the valuation price rose to $10.20, the margin holding for the customer is $1,640. This amount is in excess of Initial Margins + Variation Margins by $616 ($1,640 - $1,024).




Day 1

Day 5

Day 10

($10.00x1,000)x10%=$1,000

($9.50x1,000)x10%=$950

($10.20x1,000)x10%=$1,020


($10.00 - $9.50) x 1,000 = $500

($10.00 - $10.20) x 1,000 = - $200

MM+VM

$950 + $500 $1,450

$1,020- $200 $820

Initial Margin (IM) (assume

1.2MM)




IM+VM Margin Holding (assume prompt

payment)

Margin Call

$1,000 x 1.2 = $1,200

$950 x 1.2 = $1,140

1,020 x 1.2 = $1,224

$1,140 + $500$1,640

$1,224 - $200 $1,024

$0

$1,200

$1,640

$1,200

$440

$0


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vi) Possible Higher Margins if the Industry-Wide ES Positions are Excessive

SGX will monitor the level of global or industry-wide positions throughout the ES contract life, especially in the period leading up to the Last Trading Day, where appropriate, such as in a case where large global positions create the risk of a cornered market in the underlying, among other measures, SGX may raise margins to address this.

vii) Collateral

• Acceptable Forms of Margin Collateral

Initial Margins and Required Margins must be met in the form of collateral prescribed by SGX. Currently, the forms of collateral which may be accepted by brokers as margins are:-> Cash;-> Government Securities;-> Bank Certificate of Deposit;-> Gold Bars or approved Gold Certificates and-> Selected common stocks

Brokers have the discretion to decide which of these collateral they will accept.

Chapter 5

Trading Strategies Using ES Contracts

i) Risk Management and Hedging

The aim of using contracts, such as ES contracts, in risk management or hedging is either to achieve price certainty by locking in prices in advance or to protect against adverse price impact on the value of one’s assets. Hedgers can seek to reduce price risk by buying ES contracts to create a long hedge or selling ES contracts to create a short hedge.

Example of a long hedge

ES contracts can also be used to hedge an anticipated purchase of shares. In this case the investor wants to protect themselves against a rise in the price of shares before the purchase takes place. By buying ES contracts, the investor locks in the ‘purchase’ price for the underlying shares.

Assuming that on 1st September 2008, ABC shares are trading at S$13.00 and the September contract of ABC ES is trading at S$12.80. A fund manager or investor who has been planning to add 50,000 ABC shares to his portfolio feels that the price of ABC shares is slightly undervalued and is a good investment at this level. However, the investor’s funds from investments in fixed deposits will only be available in 2 weeks’ time. In order to lock in the investment in ABC shares without the risk of price increase, he may consider buying ABC ES contracts with a smaller outlay of funds and take delivery of the shares when the contract expires as the rest of his funds become available.

The fund manager or investor is facing a risk that the price, of 50,000 ABC shares that he plans to buy, may rise before his funds are available. Hence, he may have to pay for the ABC shares at a higher price in 2 weeks’ time.

In order to hedge his price risk, the fund manager or investor may consider locking in the price of ABC shares by buying 50 lots of ABC ES contracts at S$12.80. Initial Margin required is say S$2,000 per contract or S$100,000 for 50 contracts.

Assuming that 2 weeks later, when his funds are available, both ABC shares and ABC ES contracts rise to S$13.50.

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The gain in his ABC ES position isS$(13.50 – 12.80) x 1,000 x 50 lots = S$35,000

This gain of S$35,000 from his long ES position is his savings from purchasing the ABC shares early.

Example of Short Hedge

Investors can use ES contracts to hedge their physical shares. An investor with a long position in the underlying shares can consider taking short positions in related ES contracts and deliver the physical underlying at the maturity of the ES contract.

For example, on 2nd September 2008, ABC shares are trading at S$13.00 and the September ABC ES contract is trading at S$12.90.

An investor or fund manager is holding 50,000 ABC shares and is sitting on some paper gain. However he is worried that an important piece of news to be released next week will affect the share price.

The investor or fund manager is facing a risk that the price of his underlying asset, ABC shares, may fall.

In order to hedge this exposure, he may consider selling 50 lots of September ABC ES contracts at S$12.90 to lock in the price of his ABC shares. Assume that both the shares and ES prices fall to S$12.00 after the release of the news.

Losses on stock position = S$(12.00 – 13.00) x 50,000 = - S$50,000Gain on ES position = S$(12.90 – 12.00) x 1,000 x 50 lots = S$45,000Net loss = S$5,000 instead of S$50,000

The net loss through hedging the position is S$5,000 as compared to a loss of S$50,000 if the position was left unhedged.

• Using ES as a Hedging Tool

ES contracts also offer a better hedging tool as compared to other derivatives like warrants, as depicted below:

ES contracts Warrants

Immediate,near100%hedge(delta=1.0)

Need not select a strike price

Breakeven from buy or sell price

Cost is the cash to maintain margin, which forms part of settlement if contract is held to maturity

Greater liquidity and tighter bid/offer spreads are expected

Hedge depends on strike price and time to expiry (at the money delta = 0.5)

Must determine a strike price

Breakeven on call (put) is above (below) strike price

Cost is initial premium, which is subject to time decay

Synthetic short of long put and short call (delta = 1.0) involved 2 transactions & costs

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ii) Stock Spreads

Investors will be able to trade spreads between stocks more conveniently than in the ready market. For example, if the investor feels that, within a particular sector, company A will outperform company B (regardless of whether their respective share prices actually rise or fall), he can go long on a company A’s ES contracts while taking short positions on company B’s ES contracts.

iii) Arbitraging

ES contracts will provide opportunities for arbitraging between the ES market and the ready market. Stocks and ES prices generally move in tandem or in the same direction. That is, if the stock price goes up, the related ES price will move in the same direction. In situations whereby the underlying is cheaper or more expensive than the corresponding ES contract, arbitragers will buy the cheaper instrument and sell the more expensive instrument. Such activities will narrow the gap between cash market prices and ES prices.

This price relationship between an ES price and its underlying stock price exists also because the ES final settlement mechanism ensures that stocks and ES prices converge on the Last Trading Day when ES contracts are physically settled into the underlying.

Physical settlement means that the underlying is to be physically delivered in exchange for a specified payment (See Figure 2).

Figure 2

• ES Trading at Discount to Underlying

When an ES contract is trading at a discount to the underlying, investors who are long holders of the underlying can consider selling in the ready market and buying the ES contracts. This could include investors on margin loans, who will thereafter be able to reduce the holding costs of long term financing trades by tapping on such discounts or arbitrage opportunities that are available. Investors should note that some expenses like commissions and other fees may be incurred .

• ES Trading at a Premium to Underlying

Investors who wish to sell the securities but have no urgent needs for cash in the short term can consider taking short positions in ES contracts that are trading at a premium, at a higher price for a forward settlement date. Should the investors wish to “close off” their positions, they can also do so by taking an offsetting long position in the ES contract if the price comes down, hence locking gains. Investors should note that some expenses like commissions and other fees may be incurred.

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ES Expiration

Stock Price

ES Price(Valuation Price)

Time

Pric

e

Appendix 1

ES PHASE 1 – EARLY EXPIRATION OF ES CONTRACTS

CORPORATE ACTION: COMPANY DECLARES DIVIDEND IN UNDERLYING SHARES

Example 1.1 – Percentage of dividend is not more than 5% of underlying share price on date of announcement of dividend.

On 15 March 2008, ABC company declares a dividend of $0.30 to be paid on 31 March 2008. The Book Closure Date is 28 March 2008. The price of ABC security at the point of the announcement is $10.00Thedividendinpercentagetermsofthesecurityprice=($0.30/$10.00)x100%=3%

No adjustment will be made to the ES March and April contracts on ABC shares as the dividend falls below the 5% threshold.

Example 1.2 – Percentage of dividend is more than 5% of underlying share price on date of announcement of dividend

On 15 March 2008, PQR company declares a dividend of $0.80 to be paid on 31 March 2008. The Book Closure Date is 28 March 2008. The price of PQR security at the point of the announcement is $10.00Thedividendinpercentagetermsofthesecurityprice=($0.80/$10.00)x100%=8% The following will occur:

- the Last Trading Day of the ES March contract for PQR shares will be brought forward from 31 March 2008 to 25 March 2008.

- similarly, the Last Trading Day of the ES April contract for PQR shares will be brought forward from 30 April 2008 to 25 March 2008.

- SGX may choose to list a new ES April Contract on or after ex-date (26 March 2008), to replace the expired ES April contract.

OTHER TYPES OF CORPORATE ACTIONS

Similarly, for all other corporate actions in underlying stocks of ES contracts (such as bonus issues, stock splits, share consolidation, rights issues etc), the Last Trading Day of the corresponding ES contract will be brought forward to the market day before the ex date of the corporate action. Where early expiration occurs for an ES contract, a new ES contract may be listed on the ex-date to replace the expired ES contract.

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ES PHASE 2 – VARIOUS ADJUSTMENTS AVAILABLE

CORPORATE ACTION: COMPANY DECLARES DIVIDEND IN UNDERLYING SHARES

Example 2.1 – Percentage of dividend is not more than 5% of underlying share price on date of announcement of dividend.

On 15 March 2008, ABC company declares an ordinary dividend of $0.30 to be paid on 10 April 2008. The Book Closure Date (BCD) is 7 April 2008. The price of ABC security at the point of the announcement is $10.00Thedividendinpercentagetermsofthesecurityprice=($0.30/$10.00)x100%=3%

Similar to Phase 1, no adjustment will be made to the ES March and April contracts on ABC shares as the dividend falls below the 5% threshold.

Example 2.2 – Percentage of dividend is more than 5% of underlying share price on date of announcement of dividend

On 15 March 2008, PQR company declares an ordinary dividend of $0.80 to be paid on 15 April 2008. The Book Closure Date (BCD) is 7 April 2008. The price of PQR security at the point of the announcement is $10.00Thedividendinpercentagetermsofthesecurityprice=($0.80/$10.00)x100%=8%

SGX may choose to:

(a) bring forward the Last Trading Day.

If so, the following will occur:

- no adjustments will be made to the ES March contract for PQR shares as the BCD falls after the Settlement Date.

- the Last Trading Day of the ES April contract for PQR shares will be brought forward from 30 April 2008 to 4 April 2008.

- SGX may choose to list a new ES April Contract on or after ex-date (5 April 2008), to replace the expired ES April contract.

(b) amend the value of the ES contract

If so, the following will occur:

- no adjustments will be made to the ES March contract for PQR shares as the BCD falls after the Settlement Date

- in respect of the ES April contract, on ex-date (5 April 2008), the trade price of the contract will be reduced by the amount of the dividend that is in excess of 5% of the latest closing underlying share price, (i.e. $0.80 – (5% X $10) = $0.30) based on the last trading price of PQR ES on 4 April 2008. SGX will not list a new ES April contract.

- adjustments will be made to all positions which have not been offset as at ex date i.e. the Maintenance Margin and Variation Margin will be calculated based on the new ES contract value.

Note: SGX will publish the final corporate action adjustment methodology for Phase 2 for standard corporate action events at a later date, closer to the launch of Phase 2. Please refer to the webpage at www.sgx.com/es for updates and details on the Phase 1 and 2 of corporate action adjustments to ES contracts.

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CORPORATE ACTION: COMPANY ANNOUNCES STOCK SPLIT

Example 2.3 – Company announces 2-for-1 stock split and SGX amends the quantity of underlying shares to be delivered

On 15 March 2008, PQR company declares a 2-for-1 stock split on 10 April 2008. The Book Closure Date is 7 April 2008. Investor A has 10 lots of ES March contracts and 2 lots of ES April contracts.

The following will occur:

- no adjustments will be made to the ES March contract for PQR shares as the BCD falls after the Settlement Date.

- on ex-date (5 April 2008), positions in ES April contracts will be adjusted. Investor A, who has 2 lots of ES April contracts on 4 April 2008 will have 4 lots of ES April contracts on 5 April 2008. - in respect of the ES April contract, on ex-date (5 April 2008), the trade price of the contract will be adjusted. If the trade price of the ES April contract is $1.00 on 4 April 2008, the trade price will be adjusted on 5 April 2008 as follows:

Adjusted contract price = $1.00 / (2/1) = $0.50

- SGX will not list a new ES April contract.- Adjustments will be made to all positions as at ex date i.e. the Maintenance Margin and Variation Margin will be calculated based on the new ES contract value.


CORPORATE ACTION: COMPANY ANNOUNCES BONUS ISSUE

Example 2.4 – Company announces bonus share issue and SGX amends the quantity of underlying shares to be delivered

On 15 March 2008, PQR company declares bonus share issue (1 bonus share for every 10 existing shares held) on 10 April 2008. The Book Closure Date is 7 April 2008. Investor B has 10 lots of ES March contracts and 2 lots of ES April contracts.

The following will occur:

- No adjustments will be made to the ES March contract for PQR shares as the BCD falls after the Settlement Date.

- On ex-date (5 April 2008), the quantity of security to be delivered on Settlement Date for the ES April contract will be adjusted as follows:

Adjusted deliverable quantity = 2,000 + [2,000 x (1/10)] = 2,200

- On ex-date (5 April 2008), the trade price of the ES April contract will be adjusted. If the trade price of the ES April contract is $1.00 on 4 April 2008, the trade price will be adjusted on 5 April 2008 as follows:

Adjusted contract price = $1.00 / [2,200/2,000] = $0.90

- SGX will list a new ES April contract based on the new board lot quantity on ex-date (5 April 2008).

- Adjustments will be made to all positions as at ex date i.e. the Maintenance Margin and Variation Margin will be calculated based on the new ES contract value.

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Appendix 2

Extended Settlement Profit and Loss Calculation(Calculations do not take into consideration cost of funds)

Buying ES Contracts Resulting in Profit

An investor who holds a bullish view on XYZ stocks buys one lot of XYZ July 2008 ES contract at the price of S$19.70. When the market rises, he sells one lot of XYZ July 2008 ES contract to offset the long position, at the price of S$20.30 to take profit.

Buying ES Contracts Resulting in Loss

Another investor who holds a bullish view on ABC stock buys one lot of ABC July 2008 ES contract at the price of S$19.80. The market takes a downturn. The ES contract reached its maturity and is physically settled into the underlying. The investor then sells the underlying stock at $19.50.

Profit and Loss Calculation = (Selling Price – Buying Price) x Quantity= (S$20.30 - S$19.70) x 1,000 = S$600

Profit and Loss Calculation = (S$19.50 – S$19.80) x 1,000 = -S$300

Selling ES Contracts Resulting in Profit

An investor who holds a bearish view on PQR stocks sells one lot of PQR July 2008 ES contract at the price of S$8.40. The price falls to S$8.00 and he takes profit by taking a long position on one lot of PQR July 2008 ES contract at that price, to offset his trade.

Profit and Loss Calculation = (S$8.40 – S$8.00) x 1,000 = S$400

Selling ES Contracts Resulting in Loss

An investor who holds a bearish view on ABC securities sells one lot of ABC Corp July 2007 ES contract at the price of S$6.70. The market recovers and he decides to take an offsetting long position of ABC Corp July 2007 ES contract at S$7.10. This results in a loss calculated as follows:

Profit and Loss Calculation = (S$6.70 – S$7.10) x 1,000 = -S$400

The above examples and calculations did not take into account commission chargeable by the broker or CDP clearing fees which are payable whenever the investor enters into an ES trade.

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22

Initial Margin (IM) (assume rate = 10% & underlying

price = Valuation Price)

($10.00x1,000)x10%=$1,000

($10.20x1,000)x10%=$1,020


($10.00 - $10.20) x 1,000 = -$200 (Mark-to-market Gain)

Required Margins =

IM+VM

$1,000

$1,020 - $200 $820

Margin Holding(assume prompt

payment)

Day 1: Investor A buys 1 lot of XYZ ES at $10.00

Day 2: Valuation Price of XYZ ES rises to $10.20

Margin Call/ (Excess Margin)

(assume IM = MM)

What happens?

$1,000

$1,000

$0

-$180

Investor A needs to put up margin of $1,000 with the broker. Investor will receive a contract statement from broker. The contract statement is sent out on the market day after they have traded.

Investor A can choose to draw the excess margin the next market day.

Margin Examples

Scenario 1: Price of ES Contract Rises

Note: The example does not take into consideration the cost of funds

Scenario 2: Price of ES Contract Falls




($10.00x1,000)x10%=$1,000

($9.80x1,000)x10%=$980

($9.70x1,000)x10%=$970


($10.00 - $9.80) x 1,000 = + $200(Mark-to-market Loss)

($10.00 - $9.70) x 1,000 = + $300(Mark-to-market Loss)

Required Margins = MM+VM

$1,000

$980 + $200 $1,180

$970 + $300 $1,270


payment)


Day 2: Valuation Price of XYZ ES falls to $9.80

Day 3: Valuation Price of XYZ ES falls to $9.70


(assume IM = MM)

What happens?

$1,000

$1,000

$1,180

$0

-$180

$90

Investor A needs to put up margin of $1,000 with the broker. Investor will receive a contract statement from broker. The contract statement is sent out on the market day after they have traded.

Investor A will receive a margin call on the next day. He needs to top up margin within two days after the margin call.

Investor A will receive a margin call on the next day. He needs to top up margin within two days after the margin call.

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Scenario 3: Price of ES Contract Rises and Investor Takes Offsetting Position




($10.00x1,000)x10%=$1,000

0

($2.00 x 5,000) x 10%=$1,000

($2.20 x 5,000) x 10%=$1,100


($10.00 - $10.20) x 1,000 = -$200

- $200 + $0 = -$200

- $200 + ($2.20 - $2.00) x 5,000 = $800

Required Margins =

IM+VM

$1,000

0

$1,000 - $200 = $800

$1,100 + $800 = $1,900


payment)


Day 2: Valuation Price of XYZ ES rises to $10.20 and the investor closes out his positions by selling 1 lot of XYZ ES

Day 3: Investor A shorts 5 lots of ABC ES at $2.00

Last Trading DayValuation Price of ABC ES rises to $2.20

LTD + 1 and LTD + 2 Contract expired but margin is calculated till LTD + 2


(assume IM = MM)

What happens?

$1,000

$1,000

$0 (excess margin was withdrawn)

$800

$0

-$1,000

$800

$1,100

Investor A needs to put up margin of $1000 with the broker. Investor will receive a contract statement from broker. The contract statement is sent out on the market day after they have traded.

Investor A can choose to draw the excess margin the next market day.

Investor A only needs to put up an additional $800 margin as offsetting gains from XYZ ES trade can be used to meet required margins for ABC ES.

Investor A will receive a margin call on the next day. He needs to top up his margin within two days after the margin call.

Investor A will still need to top up margin if the market moves against him during LTD + 1 and LTD + 2.

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LTD + 3Settlement Day

ES contracts will be physically settled. That is, the investor delivers 5 lots of ABC shares and receives his profit of $200 on XYZ.

Scenario 4: Price of ES Contract Falls and Investor Takes Offsetting Position




($10.00x1,000)x10%=$1,000

0


($10.00 - $9.80) x 1,000 = $200(offset Loss)

Required Margins =

IM+VM

$1,000

$200


payment)


Day 2: Valuation Price of XYZ ES falls to $9.80 and the investor offsets his positions by selling 1 lot of XYZ ES

LTD + 3Settlement Day


(assume IM = MM)

What happens?

$1,000

$1,000

$0

-$800

Investor needs to put up margin of $1000 with the broker. Investor will receive a contract statement from broker. The contract statement is sent out on the market day after they have traded.

Investor can choose to draw the excess margin the next market day.

No additional payment required. The $200 loss may be settled with the margin holding of $200 on LTD + 3.

25 For more information on SGX ES: CALL: 1800- CALL SGX(2255 749) EMAIL: [email protected] WEBSITE: www.sgx.com/es

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APPENDIX 3

Example of a Risk Disclosure Statement which may be furnished by your broker for your acknowledgement and signature before trading in Extended Settlement contracts

31

Gl0ssary

Term Definition

Buying-in

Brokerage commission

CDP

Clearing fee

Daily Settlement Price

Dividend

Extended Settlement contract

Settlement date

Hedge

Index

Last Trading Day (LTD)

Leverage

Liquidity

The process whereby CDP buys shares on the market to satisfy the delivery obligation, if an investor does not have the required shares in his account on the settlement date.

A fee charged by a broker for his/her service in facilitating a transaction.

The Central Depository (Pte) Ltd

A fee charged by clearing corporations for their services provided to investment firms.

The official daily closing price of a certain ES contract.

A distribution of earnings to shareholders of a corporation or an investment company.

An ES contract is a contract between two parties, to buy or sell a specific quantity of shares of a specific underlying at a specific price for settlement at a specific future date when the contract matures or expires.

The day when all the open positions are settled.

A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. It involves taking equal and opposite positions in two different markets.

A statistical indicator providing a representation of the value of the securities which constitute it. Indices often serve as barometers for a given market or industry and benchmarks against which financial or economic performance is measured.

The last day during which trading may be conducted in ES.

The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

The ability to easily turn assets into cash. An investor should be able to sell a liquid asset quickly with little effect on the price.

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Term Definition

Maintenance margin

Margin

Margin call

Mark-to-market

Market maker

Open Interest

Physical delivery

SGX-ST

Short sale

Refers to that component of Required Margin, as determined by CDP, which must be maintained in a customers’ account subsequent to the deposit of Initial Margin for that customer’s positions in ES. The Maintenance margin is computed by multiplying the prescribed margin rate with the value of the ES contract.

A cash deposit provided by customers as collateral to cover losses (if any) that may result from the customers’ trading activities in ES.

Demand from a broker to a customer to deposit additional money so that the margin account (depleted by a fall in the price of the ES purchased on margin) is brought up to the minimum required margin. If a customer fails to pay within the time frame, positions in the account may be liquidated.

The daily process of revaluing outstanding positions that are not liquidated to the daily settlement price at the end of each trading day. The resulting profit and loss amount will be credited to or debited from the respective account accordingly.

A broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security.

This refers to the total number of open or outstanding contracts in the market that has not been closed out.

The actual delivery of the underlying asset of a specified ES on settlement date.

Singapore Exchange Securities Trading Limited

The sale of a security or other financial instrument not previously owned by the seller in the expectation that it will be possible to repurchase that instrument at a lower price some time in the future.

Term Definition

Stock

Underlying

Variation margin

Volatility

A type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings.

Any stock or index whose price movement determines the value of the ES.

Variation margin comprises of the mark-to-market gains and losses, in relation to the price at which the ES was bought or sold, arising from the daily valuation of positions.

The relative rate at which the price of a security moves up and down. Volatility is found by calculating the annualized standard deviation of daily change in price. If the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility.

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