Question 1

Briefly explain the derivative instrument, and how is it different from stocks and bonds.

Derivative instruments are financial instruments that derive their value from the value of an
underlying asset. Stocks represent ownership interest in companies, while bonds represent slices of
large loans to companies in exchange for regular interest payments.

If invest in stock and bond and derivative, whats the difference between them?

Derivative don’t have dividend/voting rights (capital market which has stock and bonds has it)

Benefit of derivative is PROFIT.

EG FB got value, then bankrupt, stock no value (stock got value, derivative got value, when stock no
value, derivative no value as it derives it value from underlying asset)

Physical settlement for stock is possible. (buy using the strike price)(I think its bond?) 100 u buy
convert to stock. 50 is still profit. After u sell at 150.

Question 2

Discuss the key categories of players in derivatives markets, and briefly describe the objective of
each category of players.

Hedgers are players whose objective is risk reduction. Hedgers use derivative markets to manage or
reduce risks. They are usually businesses who want to offset exposures result from their business
activities.

Speculators are players who establish positions based on their expectations of future price
movements. They take positions in assets or markets without taking offsetting positions, expecting
market to perform according to their expectation.

Arbitrageurs are players whose objective is to profit from pricing differentials mispricing.
Arbitrageurs closely follow quoted price of the same asset/instruments in different markets looking
for price divergences. Should the divergence in prices be enough to make profits, they would buy in
the market with the lower price and sell in the market where the quoted price is higher. Arbitrageurs
also arbitrage between different product markets. For example, between the spot and future
markets or between futures and option markets or even between all three markets.

/
Question 3

Explain how might the absence of speculators/speculation hurt hedgers.

i) Reduced liquidity, reduced trading volume and so higher transaction cost, as a result,
hedgers have to pay more
ii) Lack of counterparties for hedgers to pass on their risk (the hedgers they basically just
want to reduce their risks, when they wanna pass their risk to other ppl, they need
someone who willing to take their risk only they can pass on (like buyer and seller).
Hedger sometimes have imbalance order. 3 hedger seller, 1 hedger buyer, speculator
can match the order by buying the position, speculator just speculate based on their
expectation. No speculator, difficult to match the order) [ Hedgers have limited group of
people to transfer the risks by selling the derivatives instruments]

(absence of speculators, speculators will estimate and expect the price for future price movement,
hedger canot have the direction earned as

Question 4

Using appropriate example, differentiate between commodity and financial derivatives.

Commodity derivatives have tangible underlying assets like agricultural produce and metals.
Financial derivatives have financial instruments as underlying assets.

All commodity derivatives (can be cash/physical) have actual and physical settlement of underlying
commodity at maturity. Financial derivatives(can be cash/physical) [mostly] are cash-settled at
maturity and cash settlement does not involve the exchange of actual underlying asset but the
monetary equivalent of the asset.

Example of commodity derivative is wheat, soybean and crude palm oil. Example of financial
derivatives are US$, KLIBOR futures and t-bill futures.
Financial derivative can physical settlement, eg stocks.

Index canot. The physical settlement means if you hold a position in any Stock F&O contract, at
expiry, you will be required to give/take delivery of stocks. The physical settlement is restricted only
to stock derivatives. Physical settlement of index options is not applicable. Index contracts are cash-
settled only.

Question 5

Explain the benefit(s) do arbitrageurs and speculators bring to derivatives markets.

Ans: Buy from lower price market and sell in higher price market.

Speculator create inefficiencies. How?

Ans: inefficiencies happen bc speculator bc everyone has different opinions to buy and sell. Some
not rely on data, or listen ppl give advice. Depends whether market move according to ur
expectation. Zero sum game. Expectation correct = winner, wrong = loser. SPECULATOR just buy and
wait market move in their direction (one direction)

Arbitragers help ro reduce the inefficiencies. They look at price difference from one market to
another market and win

Hedger hedge based on one direction based on their risk exposure

Arbitrageurs

-Promote market efficiency as arbitrageurs, by mean of their activities, ensures that prices in

different markets (Spot, Futures, Options) do not diverge from each other.

-Enhance price discovery, by mean of their activities, seeking price divergence between markets in

different countries to “internationalizes” the product prices.

-Helps to reduce the distortionary effects of government regulation/intervention.

Speculators

-Promote liquidity and Increase trading volume, which lead to reduction in transaction cost

-Taking risk in the position that willing to accept the risk transferred by other players, especially

hedgers.

Question 6

Explain the types of risk associated with derivatives.

Inflation risk: it refers to the loss of purchasing power resulting from inflationary conditions. In high
inflationary environment, future investment returns would be worth much less, given the loss in
purchasing power.

Interest rate risk: it refers to the changes in asset values due to changes in nominal interest rates. It
is particularly important for fixed income securities due to discounting to find prices.

Default/Credit risk: It refers to the changes in financial integrity of the counterparty or the issuer of
the asset and its ability to deliver on its commitment.

Liquidity risk: It is the risk arising from thin or illiquid trading. Thinly traded instruments have higher
price volatility, and are difficult to dispose off quickly.

Exchange rate risk: it refers to changes in investment income due to exchange rate fluctuation. It is
of utmost importance in cross border transactions. Malaysia exchange rate depreciate, u need to
pay more

Malaysia depreciate, profit from US market, underlying position (return convert back to ringgit will
be more) depend on ur position oni can know whether u loss or profit exchange msia money to usd
toni can buy the CPO derivative. After u profit from derivative, convert back to msia, subject to
exchange rate. Eg Malaysian ringgit appreciate (This is the risk), usd convert back to myr will be
lesser.

Political risk: it refers to risks faced by international investors. It mostly arises due to regulatory
aspects, and refers to risks such as expropriation/nationalisation, imposition of exchange controls.

Order imbalances
Because of their risk exposure, always worry price drop

Farmer worry price go down, that’s why short. If increase in price is alrdy profit ma via long. If drop
in price, short can give them some profit.

Confectioner always worry price go up

Arbitrageur will take profit very fast (buy another market sell one market, price down), then can
control the overheating market. UNLESS the stock only in one market. But still can arbitrage, like one
stock and one warrant move differently, provided short selling avail. Long warrant, short share to fill
the gap.

Inefficient = incorrectly priced. Efficient = correctly priced.

Inefficiency is smth that is not logic, not according to the correct variation, they buy but dk what
they buy