Understanding KLCI futures contracts

Extracted from the Star Publications, 10/04/00

TWO weeks ago, Institut Bank-Bank Malaysia highlighted on futures trading in Malaysia. In this week's article, IBBM will focus on the Kuala Lumpur Composite Index Futures (KLCI Futures).

RECAPPING from the previous issue, a futures contract is a legally binding agreement, made on the trading floor of a futures exchange or via the exchange's electronic screen dealing system, to buy or sell something in the future.

That "something" could be gold or copper, wheat or corn, a foreign currency, shares or interest rates. Each contract specifies a commodity, the quantity, quality and time of delivery or cash settlement.

The buyer and seller of a futures contract, although they never see each other, agree on a price today for a product to be delivered and paid for in the future. That is why it is called a futures contract.

Futures contracts based on stock market indices first commenced trading in the United States in 1982. In Malaysia, the Kuala Lumpur Composite Index (KLCI) futures contract was introduced in December 1995. These contracts enable portfolio managers, underwriters and others to reduce risks associated with price fluctuations in the equity market.

The KLCI futures are based on the Kuala Lumpur Stock Exchange (KLSE) Composite Index (CI), a widely-used representation of the Kuala Lumpur share market as a whole, reflected by the market prices of the top 100 Malaysian companies listed on the KLSE.

Initial Margins

As described in the earlier issue, before entering into a futures contract, each trader in the market is required to open a trading account with a member company and to deposit an amount of money called an initial margin.

This initial margin is by nature a performance bond and is required to protect the interest of both the broker and the other participants in the market. The amount required to be deposited is between RM6,000 to RM10,000 per KLCI futures contract.

Depending on the open position, the trader is also subjected to a variation margin where the amount is either credited into the account (when the open position is favourable compared to the end-of-day settlement price), or called for margin (if the open position incurs a floating loss).

If at any stage a trader is unable to meet a margin call to cover a market move against him, his position may be closed out and the resulting loss deducted from the initial margin before the balance is returned. If margin calls are met, or if profits are realised on a futures transaction, the initial margin is credited with the profits the same time the contract is closed out.

The amount required as initial margin is set by the clearing house and is subject to change from time to time.

Risks inherent in the equities market

The KLCI futures market, more importantly, is to provide a facility for the management of risk caused by price change in the equities market. Everyone who trades the equities market, or who holds a portfolio of shares, including companies that underwrite shares, is subject to such risk.

In fact, 2 major types of risk in the share market can be identified as:

Specific risk

This is the risk specific to the company that affects the price of the shares. It includes the company's earnings, business performance and management as well as other factors relating specifically to that particular company.

A way to balance this specific risk is to diversify one's shareholding by spreading an investment portfolio across a number of different industries, so that a decline in price in 1 stock is likely to be offset by a rise in price in others.

Diversification reduces specific risk but does not entirely eliminate it. Individual stock futures can provide a more effective method of protecting investors against adverse movements in individual stocks.

Market Risk

This risk affects the equity market on the whole, i.e. will it rise or fall. Along with the factors which have an effect on prices of individual shares, are a number of factors which have an impact on the state of the entire market.

Among the most important factors are interest rate levels. If interest rates rise, the performance of many businesses will be adversely affected by the resulting increase in operating costs, and the market as a whole will tend to fall.

Higher interest rates will also attract funds out of equities and into higher yielding fixed interest investments. Increasingly, international investment in Malaysian equities results in overseas investors causing general movements in the market.

In addition, fluctuations in ringgit can cause foreign investors to change their level of Malaysian equity exposure, thus exacerbating market risks.

Uses Of The KLCI Futures

Hedging by portfolio managers: This market risk can be reduced by the appropriate use of KLCI futures. For example, portfolio managers who are expecting to receive capital to invest in shares some time in the future, may use KLCI futures as a means of pricing those future acquisitions.

The risk here is that the market will rise before the capital to be invested is received, which would increase the costs of shares to be purchased. They would buy KLCI futures, so that any rise in the market would be offset by a gain in the futures market. This is known as anticipatory hedging.

Portfolio managers who already hold a portfolio of shares may use KLCI futures to protect against a fall in value of their portfolio. The risk here is that the market will fall and so they would sell the KLCI futures in order to profit from a falling physical market. This is called portfolio hedging.

Speculators use KLCI futures in an attempt to profit from market movements. Speculators will buy KLCI futures when they expect the market to rise. Conversely, they can sell the KLCI futures when they expect the market to fall. Speculators provide the important contribution to the liquidity of the futures market.

Conclusion

We hope this article has been helpful in providing information for a better understanding of the KLCI Futures.

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