1.1 FUTURES VS of KLIBOR VS Three Month KLIBOR VS Futures Contract
Futures are a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today. A futures contract can be offset to maturity by an equal and opposite transaction. (Three month KLIBOR futures, 2010)
Kuala Lumpur Inter-bank Offered Rate (KLIBOR) is an interest rate derived that borrowing and lending funds in the inter-bank market (3 month KLIBOR futures, 2010). Commercial and merchant banks, discount houses, finance companies and Cagamas bid comprising for funds or offer to lend from or to each other in the inter-bank market through money brokers (3 month KLIBOR futures, 2010). The KLIBOR used by some banks as a benchmark for pricing loans to corporate bodies (3 month KLIBOR futures, 2010).
The three months KLIBOR futures contract is a financial futures contract based on the three months Kuala Lumpur inter-bank offered rate. (Three month KLIBOR futures, 2010) The interest rates pegged to the 3-month Kuala Lumpur Inter-Bank Offered Rate (KLIBOR), which mean the KLIBOR rate, are changed every three months. Three month KLIBOR Futures contract are traded by Bursa Malaysia Derivatives BMD.
1.2 History of Three Month KLIBOR Futures contract
Three Month KLIBOR Futures contract was launched in May 1996. (Highlight on Malaysian KLIBOR futures traded on Malaysia Derivatives Exchange, 2002) that providing a necessary hedging and trading tool for the Malaysian money market. (Highlight on Malaysian KLIBOR futures traded on Malaysia Derivatives Exchange, 2002)Market participants use to eliminate risks. (Highlight on Malaysian KLIBOR futures traded on Malaysia Derivatives Exchange, 2002) RM1mil for one contract, with quarterly cycle contract months of March, June, September and December that there will be an inverse relationship between the futures price and interest rates. (Highlight on Malaysian KLIBOR futures traded on Malaysia Derivatives Exchange, 2002) If one thinks that short-term rates will rise tomorrow, one should sell the futures today. (Highlight on Malaysian KLIBOR futures traded on Malaysia Derivatives Exchange, 2002) In Malaysia, these types of financial futures provide a quick, efficient and cost effective means of obtaining exposure to the cash and debt markets that trading becomes more sophisticated, frequent and common place. (Highlight on Malaysian KLIBOR futures traded on Malaysia Derivatives Exchange, 2002)
2.0 LITERATURE REVIEW
According to Rendlemen and Carabini (1979), they find that in the absence of transaction cost, the nearby futures contracts have been overpriced while longer-term futures contracts have been underpriced.
There are several studies about the price efficiency of 3-month KLIBOR futures contract. In pricing the futures contracts, they determine IFR by extrapolating short-term rates via bootstrapping to determine 6-month rates.
The bootstrapped rates are then used in determining the IFR and the theoretical futures price. They find the nearby contracts to be overpriced while the distant ones underpriced. The mispricing tended to decline as the contract approached maturity. (Taufiq, 2006)
Shamsher and Taufiq (2007) studied on the Asian derivative markets. The aim of this research is to examine the current status of selected commodity and financial derivative markets in Asia. The selected markets are included Indian, Korean, Hong Kong, China, Malaysia, and Japan and Singapore derivatives markets. According to the research from Shamsher and Taufiq (2007), there are 19 derivative markets in Asia. Its conclusion suggests that the liquidity commodities markets and active financial derivative markets are more developed by industrial or advanced economies. However, it is explain that the most of the 19 derivative markets or emerging markets still at an early stage in develop of the derivative markets.
Mubin and Mahmood (n.d) studied the co integration and the term structure of Malaysian interest rates. The aim of this study is to examine the interest rates of term structure of different maturities. The monthly data of Malaysian Treasury Bills and Kuala Lumpur Interbank Offer Rates (KLIBOR) for short term money market interest rates as well as Malaysian Government Security for long term interest rate were used. A total of 98 observations are collected from Bank Negara Malaysia with the period from 1997 t0 2004. The co integration tests and error correction model (ECM) are applied in this study.
The results support the expectations hypothesis for interest rates between short terms maturities. The expectations hypothesis is the yields of the different maturity appear to move together through time. However, the hypothesis is rejected when short-end and long-end maturities are paired and analyzed. Besides, the yield curve has limited predicting power in determining interest rates with long-end maturities.
According to Bhattacharya and Fulghieri (1994) , a model of optimal interbank coordination through borrowing and lending when each of large banks faces timing uncertainly in the return on its short-term or liquid investments. Since the extent of its ex ante investment in such liquid assets is assumed to be privately observed by each bank, it is consistent to assume that conditioning interbank contracts on such investment or their time of realized return is not also feasible. Hence, the problem of the interbank coordination with such private information is inherently a second best one, which led to distortions in the pattern of choice over short term and long term investment at each bank. They found that if investment in liquid assets and their realized returns are information to the individual’s banks the first best allocation is not incentive compatible and can characterize the second best interbank solution.
Krehbiel and Adkins (2007) examine extreme daily changes in U.S. dollar LIBOR rates and applying extreme value techniques to estimate risk statistic. The data for this study were obtained from the British Banker’s Association throughout the periods 1986 to 2005. The market risk factors examined in this study are one, three, six , nine and twelve month LIBOR rates. Daily changes in these series are used to estimate parameters of the Generalized Pareto distribution.
The likelihood of extreme daily changes in LIBOR rates are estimated using the peaks over threshold method developed from extreme valuetheory. They find that the tails of the distribution of daily simple changes in LIBORs are not well approximated by the Generalized Pareto distribution and hence not amenable to use of extreme value analysis via the POT method. The main consequence of this is that the risk statistics associated with a given change in the LIBOR depend on the initial rate level that is at higher interest rate.
According to Kuwait Financial Centre S.A.K. “Markaz” R E S E A R C H, Malaysia, Korea and India as Asian country are more specialized in futures and index product which are demutualized compare to country such as Hong Kong and Singapore that has been fully demutualized partly as opposed to foreign exchange. Besides, even through Malaysia, china, Indonesia, Thailand and Filipinas enjoy strong trading transaction in cash market, their derivatives market still very limited. in addition, India and Malaysia have less than half of notional amount per trade in between Asia country and less than 1/3the notional amount per trade in US Contract size in developing country has been double up since 2003.
Derivatives products are basically develop to balance or as a treatment for some financial problem like risk and volatilities yet derivatives are able to create financial problem other than stabilize economic condition such as crisis that occurred in year 1990 through hedging activities or speculative purpose. ( Ayca Sarialioglu-Hayali, 2007)
“A futures contract is an agreement between a seller and a buyer that calls for the seller to deliver to the buyer a specified quantity at a fixed time in the future, and at a price agreed in the contract. (Shamsher. M & Taufiq.H. , 2000). Stock index futures contract specify as the underlying asset. (Shamsher. M & Taufiq.H. , 2000). When the actual futures price deviates from the fair price by more than transactions costs (Shamsher. M & Taufiq.H. , 2000).The pricing efficiency of the futures contracts was determined by the standard error between the closing actual and theoretical fair values for each month FKL1 futures contract. (Shamsher. M & Taufiq.H. , 2000). The actual futures prices do not converge towards theoretical prices with the passage of time. (Shamsher. M & Taufiq.H. , 2000). The fair price of a futures contract is determined by a pricing model (Shamsher. M & Taufiq.H. , 2000). Real futures markets are not perfect and always be opportunities to arbitrage the differences in the fair and actual prices of futures contracts and in the process aligning these prices” (Shamsher. M & Taufiq.H. , 2000).
“The impact of index futures introduction on underlying stock market volatility is well researched especially in the case of the US, UK, Japan and Hong Kong. (Bacha, O.I., Jalil O. and Othman, Khairudin, 1999).Most of the studies finds little or no evidence of increased stock market volatility following futures introduction. (Bacha, O.I., Jalil O. and Othman, Khairudin, 1999). According to Pericli and Koutman examine S&P 500 returns over the period 1953 to September 1994 finds no incremental effect on underlying market volatility. As a result of the introduction of index futures or of options to confirm the findings of Santori who used daily and weekly returns for S&P 500 (Bacha, O.I., Jalil O. and Othman, Khairudin, 1999).Miller and Galloway (1997), examine the Mid Cap 400 index for evidence of volatility change following the introduction of a futures contract on the index. They find no evidence of any increased volatility. According to the Karakullukcu finds any expiration day impact on FTSE 100. (Bacha, O.I., Jalil O. and Othman, Khairudin, 1999).This is because the FTSE futures contracts settlement prices are calculated based on mid morning (Bacha, O.I., Jalil O. and Othman, Khairudin, 1999).According to Bacha and Villa arrive at similar results for the Nikkei stock and futures contracts. (Bacha, O.I., Jalil O. and Othman, Khairudin, 1999).They finds no evidence of an expiration day effect on the underlying Nikkei Index in Tokyo and these could be due to the staggered expiration dates and different final settlement prices.” (Bacha, O.I., Jalil O. and Othman, Khairudi)
3.0 OPPORTUNITY & ADVANTAGES
The most common use of futures contracts is 3-month KLIBOR futures. Three month KLIBOR futures are also known as FKB3. FKB3 is a derivatives contract that allows the seller to deliver and the buyer to receive the KLIBOR at a future date. So, 3-month KLIBOR futures is also categorizes as financial derivatives. KLIBOR offer participants many benefits which are listed below:
3-month KLIBOR futures is most actively traded compared to others financial derivatives. According to Shahabudin (2006), other successful international futures market such as Hong Kong Futures Exchange (“HKFE”) and Chicago Mercantile Exchange (“CME”) also use three-month tenor interest rate that is HIBOR and LIBOR, respectively.
Good liquidity of the underlying cash market.
KLIBOR is most liquid future contract in the interbank market if compared to other short-term money instrument. According to Marina Abdul Razak and Obiyathulla Ismath Bacha (2009), the 3-month KLIBOR futures contract has fairly good though patchy liquidity.
3-month KLIBOR is positively correlated with other short-term instruments-certificates of Depostis (CDs), bankers’ acceptances (Bas), Treasury bills (TBs), and repurchase agreements (repos). There month KLIBOR also used as a benchmark for interest charges on loans or pay interest on deposits.
Provides a mechanism for hedging as well as re-allocating risk to those more tolerant of it.
According to Shahabudin (2006), hedging is the act of transferring risk to the other party in view of changes in interest rates that will have an adverse impact on the investment in the cash market. The participants such as the borrowers can used the KLIBOR futures contract to hedge the cost in the event of rising interest rate while when interest rate falls, lenders can also hedge to protect their revenue. For example, a fund manager expects to receive an amount of money in three months’ time. The fund manager anticipates that the interest rate to fall by the time the money is invested. They will buy the interest rate future contracts that will mature at the time the money is invested in cash market to protect the investment against the fall in interest rate.
Shahabudin (2006) also stated that the manager should buy the futures contracts, as it is cheaper now and sell it later at a higher price because the price of interest rate futures contracts is inversely related to the interest rates. Using this strategy will help the fund manager to generate profits from futures contracts transaction that will offset the decline in cash market investment due to interest rate fall.
According to Shahabudin (2006), the contract can also be used to hedge the cost in the event of rising interest rate. If a corporate or financial institution treasury wants to borrow money in three months’ time and anticipate that the interest rate will increase by the time the money is borrowed. At this time, the treasurer can sell the interest rate futures contracts that will mature at the time the money is borrowed in cash market to hedge against the interest rate increase. Shahabudin (2006) also stated that the treasury should sell the futures contracts, as the price is higher now and complete the transaction by buying it later since the price of interest rate futures contracts is inversely related to the interest rates.
Greater of savings
In mortgage KLIBOR, it is the first conventional home loan pegged to KLIBOR, so the home buyers can enjoy lower rates than average market financing rates.
Fixed Quarterly Installment
KLIBOR is 3 –month basis, therefore monthly repayment is based on a quarterly fixed rate.
No Hidden Fees and charges
3 month KLIBOR have no set-up fees, maintenance fees or processing charges.
High margin of financing
KLIBOR enjoy financing margin of up to 89% as compare to average market financing rates.
Overall, KLIBOR is updated quarterly, most active index among the list above, it will go both up or down but progressively. KLIBOR is one of the most fundamental interest bases for borrowing money.
4.0 TRADING METHOD
KLIBOR futures contract is work differently from any other futures contract. This is because the borrowing or lending of KLIBOR futures contract are starts on the day the contract matures. For example, when the investors long a KLIBOR futures, it is represent that the investors are invests RM 1, 000, 000 for a period of three months which is starting from the maturity day of the contract at the futures yield rate.
However, when the investors short the KLIBOR futures, it represent the investors are borrows RM 1, 000, 000 for a period of three months which starting from the maturity day of the contract at the futures yield rate (Shakirah, 2006). Besides that, the three months KLIBOR also used as a benchmark in pricing of money market instruments. For example, the money market instruments like Bankers Acceptance are used as benchmark in pricing.
The contract size for KLIBOR futures are RM 1, 000, 000 with a three month maturity and quoted in the index terms which is 100.00 minus yield on an annual basis for a 360-day year. It indicates that there has negative relationship between futures price and interest rates. For example, if the investors predict that the interest rate will increase tomorrow, they must sell the futures contract today because the rise in interest rate will cause a drop in futures price. Conversely, if the investors forecast the interest rate will decrease, they will buy the futures contract. This is because decrease in interest rate will lead to increase in futures price.
The minimum price fluctuation refers to the smallest price which increase and decrease in the trading a given contract. The 1 tick or 0.01% refers to the tick size in percent which is equivalent to one basis point or one hundredth of one percent or RM25. It means with the given contract size of RM1 million and three month tenor, each tick has a ringgit value of RM25 per contract (RM 1,000,000 x 3/12 x 0.01%). The contract month for this three month KLIBOR futures are based on quarterly cycle months which is March, June, September, and December up to 5 years ahead and 2 serial months. The serial month contracts means that instead of the nearby contract being the closest quarterly month, contracts on the spot and following months are also available. The objective of this serial month is attempted to boost the trading volume. The trading hour for the KLIBOR futures are divided into two trading sessions. The first trading session is from 9:00 am until 12.30 pm and the second trading session is from 2.30 pm until 5.00 pm. The final trading day for KLIBOR futures contracts were expire on the third Wednesday of the contract month.
Other than that, the KLIBOR futures contract is cash settled. It is no delivery of a cash instrument upon maturity. This is because the Three Month Ringgit Interbank Deposit is not transferable. Moreover, there have three alternative methods to determine the final settlement value. It is important because it will determine the extent of a position’s gain or loss at maturity.
Finally, Implied Forward Rate (IFR) technique is use to calculated the fair value of the KLIBOR futures price. To determine the KLIBOR futures price, this IFR technique are incorporates with the KLIBOR from different tenors. This is because the futures price does not reflect the current KLIBOR but the rate is expected to prevail when the contract matures.
Below are the three months KLIBOR futures contract specifications.
Ringgit interbank time deposit in the Kuala Lumpur Wholesale Money Market with a three month maturity on a 360 day year.
Quoted in index terms (100.00 minus yield).
Minimum Price Fluctuation
0.01% or 1 tick
Quarterly cycle months of March, June, September and December up to 5 years ahead and 2 serial months.
Daily Price Limit
First trading session: Malaysian 9:00 a.m. to 12:30 p.m.
Second trading session: Malaysian 2:30 p.m. to 5:00 p.m.
Final Trading Day and Maturity Date
Trading ceases at 11:00 a.m. (Malaysian time) on the 3rd Wednesday of the delivery month or the 1 st Business Day immediately following the 3rd Wednesday of the delivery month if the 3rd Wednesday of the delivery month is not a Business Day.
Any contracts remaining open after the cessation of trading for a contract month shall be settled by the Clearing House at the cash settlement index (100.00 minus the cash settlement rate).
On the Last Trading Day, the Clearing House will obtain the KLIBOR 3-month rates from Reuters reference page “KLIBOR”. The cash settlement rate is derived by getting quotes from 20 major participants in the KLIBOR interbank market. The 5 highest and 5 lowest quotes are then eliminated to arrive at the arithmetic mean, rounded off to two decimal places, and hence the settlement rate. On this day, Bank Negara Malaysia will ensure that all the rates on the Reuters “KLIBOR” screen page are updated by 11.00 am.
Cash Settlement based on the Cash Settlement Value.
Final Settlement Value
Calculated as 100.00 minus the Three Month KLIBOR as published by Reuters Ltd. On reference page “KLIBOR” at 11:00 hours (Malaysian time) on the Final Trading Day.
In the event that the above calculation (i) cannot be made, the final settlement value shall be calculated as 100.00 minus the Three Month KLIBOR as published by Dow Jones Telerate Ltd on page number 46387 at 11:00 hours (Malaysian time) on the Final Trading Day.
In the event that the above calculation (i) and (ii) cannot be made, the final settlement value shall be calculated as 100.00 minus the Three Month KLIBOR as obtained from Bank Negara Malaysia at 11.00 hours (Malaysian time) on the Final Trading Day.
In the event that none of the above 3 calculations can be made, the final settlement value shall be determined by the Exchange.
Open position of 100 or more lots in any one delivery month, at the close of trading of each Business Day.
Speculative Position Limits
5,000 contracts, net gross Open Position for all delivery months.
(Source: Bursa Malaysia)
5.0 Data Description
Data starting from year 1997 until 2004 which the sources are obtaining from Bank Negara Malaysia and has been use in following test that as sample with 98 observation as total.
The following table is showing the different behaviour between several interests which included 3month Malaysia Treasury bill, 3 month Kuala Lumpur Interbank offered Rate.
5.1 Table I
5.2 Unit Root Test
Dickey Fuller Test -0.92892
Augmented Dickey Fuller Test (ADF 1) -1.2313
Dickey Fuller Test -1.4330
Augmented Dickey Fuller Test (ADF) -1.9470
Null and Alternative Hypothesis
H0 = Unit root exist
H1 = H0 do not true
With significant at 5%, the null hypothesis is rejected where H0 = Unit root exist both series which mean both series are stationary series as well instead of non- stationary.
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