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Module 14 Futures and Options

Additional Reading Materials on USD Crude Palm Oil Futures (FUPO)

Copyright 2009

Securities Industry Development Corporation

3, Persiaran Bukit Kiara

Bukit Kiara, 50490 Kuala Lumpur

(This document consists of 22 pages including the cover page)

Additional Reading Material USD Crude Palm Oil Futures (FUPO)

Commodity Futures – USD Crude Palm Oil Futures (FUPO)

Contents Page

Topic Objectives 1 Outlines: 1.0 Introduction 2 2.0 The futures contracts 4 2.1 Contract specifications for FUPO 2.2 Trading with palm oil futures 2.3 Users and uses of commodity futures 3.0 Trading Strategies with FUPO 8

3.1 Hedging with palm oil futures 3.1.1 Position hedge 3.1.2 Anticipatory hedge

3.2 Speculating with palm oil futures 3.2.1 Outright position 3.2.2 Spread trading strategies 3.3 Arbitraging with palm oil futures 3.3.1 No arbitrage pricing model 3.3.2 Cash-and-carry arbitrage 3.3.3 Reverse cash-and-carry arbitrage 4.0 Risks involved in trading FUPO contracts 17 4.1 Commodity Price Risk 4.2 Trading Risk 4.3 Foreign Currency Risk 4.4 Liquidity Risk 5.0 Comparative analysis between FUPO and Ringgit (MYR)denominated

palm oil futures contracts(FCPO) 18

6.0 Summary 19 6.1 Key Terms 6.2 Review Questions & Answers

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Topic Objectives

At the end of this topic, you should be able to:

Describe the features of the underlying instrument of the US Dollar denominated crude palm oil futures (FUPO) contract

State the contract specifications for crude palm oil futures contract Describe the trading mechanism and strategies for trading FUPO contracts Construct a buying and selling hedge using crude palm oil futures

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1.0 Introduction

FUPO is a USD denominated palm oil futures contract, launched by Bursa Malaysia Derivatives Bhd. in September 2008. It is considered as a commodity derivatives instrument complementing the Ringgit denominated Crude Palm Oil Futures contract (FCPO), which has been trading since 1980.

The underlying instrument for this commodity futures contract is Crude Palm Oil (CPO). As an edible oil, its worldwide demand is only second to soybean oil and it is also the most widely traded edible oil in the world. It has a balanced ratio of unsaturated and saturated fatty acids, making it an edible oil that is suitable for use in a variety of food application.

Malaysia currently accounts for 41 % of world palm oil production in 2007 and 46% of world exports, which is equivalent to 11.5% and 26% of the world's total production and exports of oils and fats respectively (source: Malaysian Palm Oil Board). Therefore, as the major producer and exporter of palm oil and palm oil products, Malaysia has an important role to play in fulfilling the growing need for oils and fats.

Palm Oil Exports To Major Countries

Country Jan-08 Jan-09 Change (Volume)

Change (%)

Jan - Dec 2008

China 257,914 154,267 -103,647 -40.2 3,794,494 European Union 108,444 142,246 33,802 31.2 2,052,769 Pakistan 121,428 223,935 102,507 84.4 1,257,396 India 37,738 203,049 165,311 438 970,734 Japan 44,183 52,924 8,741 19.8 547,468 USA 73,158 88,705 15,547 21.3 1,047,668

TOTAL 642,865 865,126 222,261 34.6 9,670,529

Source: Malaysian Palm Oil Board

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The existing Ringgit denominated Crude Palm Oil Future contract (FCPO) has been very successful since its introduction to the market and it has become the global pricing benchmark for palm oil. With the launching of FUPO, together, both products will help to consolidate Malaysia’s position as the leading price discovery centre for palm oil.

The main driving factor for introducing FUPO is to offer an avenue for funds that were previously unwilling to trade in the FCPO due to currency risk exposure. Being the first US dollar-denominated crude palm oil futures contract in the region, it also enables foreign buyers and importers to hedge their exposure to CPO price fluctuations in USD instead of Ringgit. With FUPO and FCPO trading side by side, it provides arbitrage opportunities to traders as a result of currency movement in between the Ringgit and USD contracts.

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2.0 The Futures Contracts

FUPO is a USD-denominated futures contract listed on Bursa Malaysia Derivatives Berhad. Each contract is equivalent to 25 metric tons of crude palm oil which will be cash settled upon maturity, against a final settlement price that is based on FCPO price, that is the globally accepted benchmark price for CPO. The exchange rate of USD/MYR will be taken from Bank Negara Malayisa as the conversion rate for the calculation of the final settlement value. Stated in section 2.1 are the detailed contract specifications for FUPO.

2.1 Contract specifications for FUPO

Contract Code FUPO Underlying Instrument Crude Palm Oil Contract Size 25 metric tons Minimum Price Fluctuation

USD0.25 per metric ton

Settlement Methodology

Cash Settled

Daily Price Limits A +/- 10% limit from the Settlement Prices of the preceding trading day will apply for all contract months, except for the spot month. When at least 3 non-spot month contracts are trading at the 10% limit, a 10 minute Cooling Off period will apply for all quoted months (except spot month as there are no price limits for spot month contract) during which trading shall only take place within the 10% Limit. Following the Cooling Off period, all quoted months shall be interrupted for 5 minutes, after which the price limit will be expanded to +/-15%. The 10% price limit will apply for the rest of the 1st trading session if the price limit is triggered less than 30 minutes before the end of session, and the price limit will be expanded to 15% for the 2nd trading session. If the 10% limit is triggered less than 30 minutes before the end of the 2nd trading session, the 10% limit will apply for the rest of the trading day.

Contract Months Spot month and the next 5 succeeding months, and thereafter, alternate months up to 24 months ahead

Trading Hours First trading session : Malaysian Time: 10:30 a.m. to 12:30 p.m. Second trading session : Malaysian Time: 3:00 p.m. to 6:00 p.m.

Speculative Position Limits

500 contracts net long or net short for the spot month

5,000 contracts for any single contract month except for the spot month

8,000 contracts for all contract months combined

Final Trading Day and Contract expires at noon on the 15th day of the spot

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Maturity Date month, or if the 15th is a nonmarket day, the preceding Business Day.

Final Settlement Cash settlement based on the Final Settlement Value. Final Settlement Price The average price of the Daily Spot Month Settlement Price

of the FCPO on the last 5 Business Days prior to the expiration including the Final Trading Day. The mid exchange rate of USD/MYR as at 6.00pm on each of the 4 Business Days prior to the Final Trading Day taken from Bank Negara Malaysia shall be used as the conversion price for the calculation of FCPO Daily Spot Month Settlement Value (Mid price USD/MYR multiplied by the Daily Spot Month Settlement Price of FCPO). The mid Exchange rate of USD/MYR as at noon will be used for calculation of Daily Spot Month Settlement Price for the Final Trading Day. The FUPO Final Settlement Value shall be the average of the converted FCPO Daily Spot Month Settlement Prices rounded to the nearest 25 cents.

2.2 Trading with palm oil futures

To start trading with FUPO, an investor will first need to open a futures trading account with a futures broker and deposit cash or collateral with the broker. However, a USD bank account is not required for trading. The futures broker will be able to act as an agent to licensed onshore banks, to quote exchange rates for the conversion of the MYR deposit to USD to facilitate the settlement in USD.

For Malaysian resident without domestic MYR credit facilities (borrowings in MYR), there will be no restrictions on funds flow. However, for those with domestic MYR credit facilities, conversion of MYR to USD is capped at MYR1 million per year for individuals and MYR50 million for corporate group if the investor choose to convert MYR to trade in USD. There will be no restrictions if trading is done with existing foreign currency funds. Those who carry out the transactions in MYR will be excluded from the above mentioned restrictions (Figure 1 is a flow chart of the exchange control for resident). As for foreigners, there will be no exchange controls applicable for the trading of FUPO.

The trading of FUPO will take place on Bursa Malaysia Derivatives Berhad and prices are disseminated real-time through Bursa Malaysia and a number of price reporting agencies

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2.3 Users and uses of commodity futures

The main feature of FUPO that differentiates it from FCPO and other regional commodity futures contracts is that it is denominated in USD. Therefore, all parties that are subject to USD currency risk can use it as a currency risk management tool to lock in their exposure in USD and thus eliminating the uncertainty due to USD/MYR currency fluctuation.

Major group of users of commodity futures are:

Corporate users, such as plantation companies, edible oil manufactures, bio-fuel producers and users, shipping and freight companies, will hedge to minimize their risk exposure in the underlying commodity markets.

Institutional investors, such as fund managers and trading houses will use commodity futures to manage and diversify their investment portfolios.

Individual investors or traders who trade for profit. They are an important group of liquidity providers.

The commodity futures are mainly used as a tool to:

hedge against a price increase or decline in palm oil or other close substitutes, such as soya or rapeseed oil in near future for a buyer or seller

use as an alternative for holding physical palm oil until it is required or available in the physical market

trade in a directional market movement by buying low/selling high in a bullish market or vice versa in a bearish market

take advantage of any temporary mispricing conditions between the underlying physical market and the commodity futures market. The availability of both FUPO and FCPO also provide the arbitrage opportunities from price discrepancies between these two contracts.

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Figure 1: The exchange control for Resident

Source: Bursa Malaysia Derivatives Berhad.

Resident

Resident without Domestic MYR Credit Facilities

Resident with Domestic MYR Credit Facilities

Pay in USD; Receive in USD/MYR orPay in MYR;

Receive in USD

Pay in MYR;Receive in MYR

Pay in USD; Receive in USD/MYR orPay in MYR;

Receive in USD

Pay in MYR;Receive in MYR

Conversion of MYR is capped (per year) at:. MYR 1 million for individuals. MYR 50 million for corporate group

No restrictions on funds flow

Trading Participants

USD CPO Futures

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3.0 Trading Strategies with FUPO

3.1 Hedging with palm oil futures Hedging is used by individuals and corporations that make purchases and sales in the commodity futures market for the purpose of establishing a known price level in advance, for something they later intend to buy or sell in the physical commodity market. In this way they attempt to protect themselves against the risk of an unfavourable price change in the interim.

3.1.1 Position hedge

A position hedge is to take a futures position that is equal and opposite to a position held in the physical market in order to mitigate the risk of an adverse move in prices of the underlying commodity. For example, a producer of crude palm oil has the risk that the cash price will decrease before the palm oil is being harvested and can be sold to overseas market. Therefore, he can choose to sell FUPO, which is a USD-denominated palm oil futures contract to mitigate this risk. Subsequently, when the crude palm oil is being harvested, if the cash palm oil price in fact declines, the futures price will have decreased as well since both the futures and the underlying commodity are highly correlated. Then, the producer can buy back (or offset) the futures contract at a price that is less than the price he sold it for, generating a profit. This profit can then be applied to the revenue he gets from selling the palm oil in the cash market, thereby mitigating the cash price decrease.

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For simplicity, the examples quoted below are excluding transaction costs.

Month Cash Market Futures Market

Current price = USD 563/metric ton Sell 4 June FUPO contracts @ USD563/metric ton

Plantation owner expects to harvest Total futures value = 4 x 25 x 563 100 metric tons CPO for sale in near future

= USD 56,300

March

Current price = USD 550/metric ton Current price = USD 550/metric ton

Sell 100 metric tons CPO = 100 x 550 Close the position by buying 4

= USD 55,000 June futures = 4 x 25 x 550

= 55,000

Adding profit from Futures Net profit = USD 56,300 - 55,000

= USD 56,300 = USD 1,300

Effective price/metric ton

= 56,300/100

= USD 563/metric ton

June

3.1.2 Anticipatory hedge

Individuals and corporations can lock in the prices of the underlying commodity that they intend to purchase or sell in the future by buying or selling the commodity futures contract. In this way they attempt to protect themselves against the risk of an unfavourable price change in the interim. However, in doing so, they forego the potentials of making profit in the event the prices of the underlying commodity go favourable, in exchange for the elimination of the downside risk. Example, an overseas refiner needs to purchase 250 metric tons of processed palm oil to fulfil an order in 3 months time. He is anticipating that the crude palm oil price is moving in an uptrend, but he does not want to buy now due to logistical issues. The current CPO price in the physical market is @ USD 563/metric ton and the futures price for May, which is 3 months’ time, is @ USD 565/metric ton. Assuming when it’s time for the refiner to obtain the 250 metric ton of CPO in the physical market in May, the CPO price in the cash market has reached USD 570/metric ton. He can now close his position in the futures by selling the 10 FUPO contracts and use the profit of USD 1,250 from the futures contracts to offset the higher cost of buying the CPO in the physical market. Therefore, his effective cost of CPO will end up at USD 565/metric ton instead of USD570/metric ton.

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With the availability of FUPO, the refiner can now trade in USD and thus avoiding the currency risk due to exchange rate fluctuation.


Current price = USD 563/metric ton Buy 10 May FUPO contracts @ USD565/metric ton

Oil refiner required 250 metric ton Total futures value = 10 x 25 x 565

in 3 months time = USD 141,250

Feb

Current price = USD 570/metric ton Current price = USD 570/metric ton

Buy 250 metric tons CPO = 250 x 570 Close the position by selling 10

= USD 142,500 May futures = 10 x 25 x 570 = 142,500

Cost of buying after deducting profit from futures = USD141,250

Net profit = USD 142,500 - 141,250

= USD 1,250

Effective price/metric ton

= USD141,250/250

= USD 565/metric ton

May

3.2 Speculating with palm oil futures

Speculating is basically the action of betting on where the market is heading based on the speculators’ opinion. For example, if a speculator is of the view that the price of the commodity futures is going on a down trend, he may short sell the futures contract and wait for the price of the futures contract to decline, at which point he will close his position by buying back the contract and receive a profit. While hedgers buy or sell futures contracts to protect them from the adverse price movement of the underlying commodity, speculators seek to profit from the anticipated increase or decrease in the futures price. In doing so, they help to provide the liquidity needed to facilitate hedging. However, speculators are facing higher risks than hedgers.

3.2.1 Outright position

The commodities futures markets provide speculators with an easy mechanism to speculate on the price of underlying commodities, without the need of holding physical commodities. For example, if someone is expecting the price of the crude palm oil to go in an uptrend in the near future, he can seek to profit by buying futures contracts now and sell when the futures price hit his target. However, if the price declines rather than increases, the trade will result in a loss. Because of the leverage of a futures position, the gain or loss may be greater than the initial margin deposit.

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For example, a trader starts his trading account with an initial margin of $5,000 and buy 1 FUPO contract at the price of $1,000/metric ton. At the end of each day, the broker will mark-to-market the contract that the trader buy based on the settlement price determined by Bursa Derivatives and the trading account will be credited for profit or debited for loss of the day. If the balance in the account falls below the maintenance margin, then a margin call will be made and the investor will be asked to either top up the account or close his position. Assuming at the end of the 6th day, the price reaches $1,050/metric ton and the trader decides to close his position by selling off the contract. However, within that 6 day period, he had topped up his margin account with an additional $2,500, thereby making his total invested capital to be $7,500. His net profit for this investment will be calculated as follows (refer to table below for more details): Net profit = (Selling price – buying price) X 25 = ($1,050 - $1,000) X 25 = $1,250 Net profit% = $1,250/$7,500 =16.67% FUPO price change % = ($1,050 - $1,000)/$1,000 = 5% From the above calculation, even though the value of the FUPO only appreciates by 5% during that 6 days period, however, due to leveraging effect, the net profit % that is obtained by the investor is 16.67%.

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Source: USD Crude Palm Oil Futures (FUPO), Bursa Malaysia Derivatives Bhd

Day / Action Settlement Price FUPO Jun06 (USD)

Account Balance (USD)

Explanation

Day 1 You deposit $5,000 in your trading account

5,000

Margin required for each lot of FUPO Jun06 contract :

Initial Margin: $5,000

Maintenance Margin: $ 4,000

Day 2 You Buy 1 FUPO Jun06 contract @ $1000 1,020

5,000

+ 500

= 5,500

A profit of $500 is credited to the account.

($1020-$1000) X 25 = $500

Day 3 Price of FUPO Jun06 drops 1,010

5,500

- 250

= 5,250

A loss of $250 is debited to the account.

($1010-$1020) X 25 = -$250

Day 4 Price of FUPO Jun06 drops drastically

900

5,250

- 2,750

= 2,500

A further loss of $2750 is debited to the account.

($900-$1,010) X 25 = -$2,750

A margin call is issued as the account balance is now less than the maintenance margin requirement of $4,000

You have the following choices:

(1) Top up the margin account to the initial margin level of $5,000; or

(2) Close out your open position

Day 5

You chose to top up your account and maintain your positions.

Price of FUPO Jun06 recovers

1,000

2,500

+ 2,500

+ 2,500

= 7,500

You deposit $2,500 to restore you minimum Initial margin level at start of day

At the end of the trading day, a profit of $2,500 is credited to the account.

($1,000-$900) X 25 = $2,500

Day 6

Price of FUPO Jun06 rises again. You decide to close out your position by selling all 1 FUPO Jun06 contract at $1,050

1,050

7,500

+ 1,250

= 8,750

A profit of $1,250 was credited to the account.

($1,050-$1,000) X 25 = $1,250

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During a bear market, the speculators can also profit from the down market by short selling the FUPO futures, and buying back when the price drops below a certain target. A trader starts his trading account with an initial margin of $5,000. He short sells 1 FUPO contract at $1,050/metric ton and buys it back to close his position after the price has dropped to $1,000. His profit will be calculated as follows: Net profit =(Selling price – buying price) x 25 = ($1,050 - $1,000) x 25 = $1,250 Net profit% = $1,250/$5,000 =25% FUPO price change % = ($1,050 - $1,000)/$1,000 = 5%

Settlement Account

Action Price FUPO Balance

Jun06 (USD) (USD)

Explanation

You deposit $5,000 in Margin required for each lot of

your trading account

FUPO Jun06 contract

Initial margin: $5,000

Sell 1 FUPO Jun06 1,050 5,000 Maintenance margin: $4,000

contract @ $1,050

Buy 1 FUPO Jun06 1,000 5,000 A profit of $1,250 is credited to the account.

contract to close the + 1,250

position = 6,250 ($1,050 - $1,000) x 25 = $1,250

3.2.2 Spread trading strategies

Spread trading involves the purchase of one futures contract and the sale of another futures contract concurrently in the hope of profiting from a price divergence. As the profits or losses occur only as the result of a change in the price difference, rather than a change in the overall level of futures prices, spreads are usually considered as more conservative and less risky compare to an outright long or short futures position.

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For example, in November, the March FUPO price is presently $500/metric ton and the May FUPO price is presently $510/metric ton, a difference of $10. Based on the analysis of market conditions, the trader is of the opinion that over the next few months, the price difference between the two contracts will widen to become greater than $10. In order to profit from this widening gap, he could sell the March futures contract (the lower priced contract) and buy the May futures contract (the higher priced contract). Assume time and events prove him right and that, by February, the March futures price has risen to $505 and May futures price is $525, thus resulting in a difference of $20. By liquidating both contracts at this time, you may realize a net gain of $10/metric ton. Since the size of each contract is 25 metric tons, the total gain is $250. ($10 x 25)

Sell March FUPO Buy May FUPO Spread November

$500 $510 $10

Buy March FUPO Sell May FUPO Spread February

$505 $525 $20

Gain/Loss $5 loss $15 gain

Had the spread (i.e. the price difference) narrowed by $10/metric ton rather than widened by $10/metric ton, the transactions just illustrated would have resulted in a loss of $250.

Sell March FUPO Buy May FUPO Spread November

$500 $510 $10

Buy March FUPO Sell May FUPO Spread February

$495 $495 0

Gain/Loss $5 gain $15 loss

Spread trading strategies can be carried out using two different months’ contract (intra-commodity spread) or between two different futures contracts (inter-commodity spread), such as FUPO and FCPO to capitalize on the temporary price difference.

Example: On Jan 2, March FUPO contract is trading at US$492.9/ton metric while March FCPO contract is trading at RM 1711/ton metric (converted to US$478.6 @ exchange rate of RM3.575/USD). The difference between these two contracts is at US$14.3. A trader believes that the inter-commodity spread between these two futures will continue to widen in the near future.

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Therefore, he could profit by purchasing the March FUPO contract and at the time short selling the March FCPO contract.

On Jan 12, the prices of March FUPO and FCPO are at US$590 and RM1959 (converted to US$564.3 @ exchange rate of RM3.4715/USD) respectively. The spread between these two contracts has widened to $25.7. The trader will close his positions by selling the March FUPO and buying the March FCPO. At this time, he has made a profit of $11.4/ton metric or $285.5/contract (25 x $11.4).

Sell March FCPO Buy March FUPO Spread

Jan-02 $478.6 $492.9 $14.3

Buy March FCPO Sell March FUPO

Jan-12 $564.3 $590.0 $25.7

Gain/Loss $85.7 loss $97.1 gain

3.3 Arbitraging with palm oil futures Arbitraging with palm oil futures is the simultaneous purchase of the physical palm oil commodity against the sale of a FUPO contract, or vice versa, to lock in a minimum risk profit from unequal prices.

3.3.1 No arbitrage pricing model

The law of one price states that in a competitive market, if two assets are equivalent from the point of view of risk and return, they should sell at the same price. If the price of the same asset is different in two markets, there will be arbitragers who will buy in the market where the asset sells cheap and sell in the market where it is costly until the prices in the two markets reach an equilibrium. Hence, arbitrage helps to equalise prices and restore market efficiency. Based on the no-arbitrage model, the fair price of palm oil futures should be calculated as:

F = S [ 1 + (r x t/365) + (c x t/365)]

where: F = futures price of the commodity S = spot price of the commodity r = annual risk-free interest rate (cost of financing) t = Time till expiration

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c = annualized cost of storage (%)

3.3.2 Cash-and-carry arbitrage An arbitrageur notices that FUPO futures seem overpriced. He can cash in on this opportunity to earn riskless profits by using a cash-and-carry arbitrage. For example, crude palm oil in the physical market is trading at USD 550/metric ton. 2nd month FUPO contract is trading at USD 580/metric ton. Based on the no-arbitrage pricing model, with the assumption that borrowing cost is at 6% and storage cost is at 5%, the fair price is USD555/metric ton. Therefore, at USD580, the FUPO contract seems to be overpriced. F = USD550 [1 + (6% x 30/365) + (5% x 30/365)] = USD555 The trader could make riskless profit by entering into the following set of transactions. Assume he buys 250 metric tons of CPO. He will borrow the cost of buying of USD 137,500 (USD550 x 250) at an interest rate of 6%. He then stores the physical commodity for 1 month at a storage cost of 5%. At the same time, he sells 10 2nd month FUPO contracts @ USD580/metric ton. After one month, the spot price for CPO is USD560/metric ton. He sells the CPO in the physical market for USD140,000 and unwinds his FUPO position by buying 10 FUPO contracts with a profit of USD5,000. After paying off his loan + interest cost + storage cost, his riskless profit is USD6,257 (refer calculation shown in the table below).


Borrow USD 137,500 to buy 250 metric ton CPO @ USD550 per metric ton (550 x 250)

Sell 10 FUPO contracts @ USD 580/metric ton

Borrowing cost @ 6% = USD678 Value = 580 X 25 X 10 (6% x 30/365 x 550 x 250) = USD 145,000

Store for 1 month,

storage cost @ 5% = USD565

(5% x 30/365 x 550 x 250)

May

Sell 250 metric ton in cash market @ USD560

June futures now at USD560 Unwind the position by buying 10 FUPO contracts

Value = USD560 x 250 Value = USD140,000

= USD 140,000 Profit from FUPO = USD5,000

June

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Cash on hand ($140,000 + $5,000) $145,000

Less: Loan $137,000 Borrowing Cost $678 Storage Cost $565 $6,757

When does it make sense to enter into an arbitrage? If the cost of borrowing funds to buy the commodity and the cost of storage is less than the arbitrage profit, it makes sense to arbitrage. However, in the real world, in order to exploit an arbitrage opportunity, it involves simultaneous trading on the spot and futures market. Therefore, one has to build the transactions costs into the arbitrage strategy.

3.3.3 Reverse cash-and-carry arbitrage

On the other hand, if the FUPO seems to be underpriced relative to the spot market, then a reverse cash-and-carry arbitrage is made possible by buying the FUPO contracts and at the same time selling in spot market. It is the exact reverse of a cash-and-carry arbitrage. However, in real life, this type of arbitrage is hardly practised on CPO due to the perishable nature of the CPO and difficulties in borrowing in cash market.

4.0 Risks involved in trading FUPO contracts

Trading in FUPO contract, as in any commodity futures trading, involves a high degree of leverage, which allows the possibilities of large returns and at the same time, large losses. Due to the high degree of risk involved in high leverage, anyone involved in FUPO trading should be aware of the risks inherent in it.

4.1 Commodity Price Risk

Commodity prices are determined by the supply and demand conditions in the market, thus, sensitive to business cycle. In addition, the prices can also be volatile as they are affected by many other unpredictable factors, such as weather, change in government policies and financial or economic distress.

4.2 Trading Risk

As trading in FUPO involves leveraged trading, it will magnify the effect of a given change in price, which will result in significant losses if the market moves against the trader’s expectation. As the amount of initial margin is small relative to the nominal value of the futures contract, a relatively small market movement will have a proportionately larger impact on the funds that the trader has in his trading account.

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If the margin levels are increased or when there are margin calls, the trader will be called upon to pay substantial additional funds on short notices in order to maintain his position. If he fails to comply with a request for additional funds within the time prescribed, he faces the risk of forced liquidation at a loss and will be liable for any resulting deficit in his trading account.

4.3 Foreign Currency Risk

As FUPO is denominated in USD, for those who trade in MYR or other currencies, the profit or loss in transactions will be subjected to fluctuations in currency rates. This is especially significant at times when the currency is experiencing high volatility.

4.4 Liquidity Risk

FUPO is a relatively new futures product in the market. In order to facilitate a liquid market so that futures participant can freely buy and sell contracts, market makers play an important role in providing the liquidity needed. Currently, FUPO is lacking of liquidity in the market as it is not being actively traded yet.

5.0 Comparative analysis between FUPO and Ringgit (MYR) denominated palm oil

futures contracts (FCPO)

Contract Specification FUPO FCPO

Final Settlement methodology

Cash settled upon expiry

Physical delivered upon expiry

Need to pay attention to the contract grade and delivery points

Currency denomination USD denominated

Exposed to USD currency risk if required to convert to MYR

MYR denominated

Exposed to MYR currency risk if required to convert to other currencies

Final Settlement value Final settlement value shall be the average price of the daily spot month settlement price of the FCPO on the last 5 business days

Conversion to USD is based on the mid exchange rate of USD/MYR at 6.00pm on each of the 4 Business Day prior to the Final Trading Day and at noon on the Final Trading Day.

Final settlement value based on the daily sport month settlement price of FCPO

No conversion required. Prices are stated in MYR

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6.0 Summary

In this topic, we have described the unique features of the US Dollar denominated crude palm oil futures (FUPO) contract and explore the various uses of FUPO, including hedging, speculating and arbitraging, and the risks involved in trading FUPO. In addition, we have also included a comparative analysis between FUPO and FCPO.

6.1 Key Terms

Position hedge Cash-and-carry arbitrage Anticipatory hedge Reverse cash-and-carry arbitrage Outright position Spread trading

Glossary Position hedge: to take a futures position that is opposite to the current physical position held Outright position: a position in a futures contract that is not offset

6.2 Review Questions

Question 1 Based on the contract specifications for FUPO, determine whether the following statements are true or false: a) The underlying instrument for FUPO is crude palm oil. b) The settlement methodology for FUPO is physical

settlement.

c) The contract size for FUPO is 20 metric ton per contract. d) The speculative position limit is 500 contracts net long

or net short for the spot month.

e) The FUPO is USD-denominated

Answer: a) True b) False – it is cash settlement c) False – it is 25 metric ton per contract d) True e) True

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Question 2

A trader buys 5 FUPO contracts at USD576/metric ton. A week later the price of the FUPO contract rises to USD 580/metric ton and he closes his position. How much profit/loss has he made on his position?

Answer:

Profit/metric ton = sell price – buy price = USD580 – USD576 = USD4/metric ton

Total profit $ = USD4 x 25 x 5 = USD500

Question 3

A trader short sells 10 FUPO contracts at USD575/metric ton. 4 days later the price of the FUPO contract drops to USD565/metric ton and he closes his position. How much profit/loss has he made on his position?

Answer:

Profit/metric ton = sell price – buy price = USD575 – USD565 = USD10/metric ton

Total profit $ = USD10 x 25 x 10 = USD2,500

Question 4

In May, a purchasing officer for an US oil refinery company plans to purchase 1000 metric tons of crude palm oil in 3 months time. He intends to lock in the purchase price now.

The current CPO price in the cash market is @ USD 560/metric ton and the futures price for Aug, is @ USD 580/metric ton.

a) Should he buy or sell FUPO contracts to lock in his purchase price? b) How many FUPO contracts does he need in order to be fully hedged? c) Assuming when it’s time for the refiner to obtain the 1000 metric ton of

CPO in the physical market in Aug, the CPO price in the cash market is USD 550/metric ton and the Aug FUPO contract price is USD 550/metric ton. i) What is the profit/loss of the FUPO position when it is closed? ii) What is the effective price that the company has paid for the 1000

metric tons of crude palm oil?

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Answer:

a) The purchasing officer should do an anticipatory hedge to lock in the CPO purchase price and buy FUPO contracts, which are USD denominated, as his dealings are in USD dollar.

b) He should buy 1000/25 = 40 FUPO contracts to fully hedge. c) (i) FUPO loss/metric ton = USD550 – USD580 = -USD30/metric ton

Total loss in the FUPO position = -USD30 x 25 x 40 = -USD30,000 (ii) Buy 1000 metric ton of CPO in cash market at USD550/metric ton. Cost of purchase = 1000 x 550 = USD550,000 Net cost/metric ton after considering the loss from FUPO = USD(550,000 + 30,000)/1000 = USD580/metric ton

The effective price of the purchase is the same as the price that the purchasing officer has locked in using the FUPO hedge.

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