Part A (14 marks)
Explain your hedging strategy and show your hedging outcome. You are required to use the real market data for your daily marking to market calculation and the outcome of the hedging strategy. Assuming the initial margin requirement is 2% of the open position value and maintenance margin is 70% of the initial margin.
A hedger must be able to purchase securities and hold them until the portfolio risk is low. The price variation is the main problems that the hedger intends to avoid thus they can lock in a purchase of the underlying asset thereby passing the risk of price variation to the speculators in the futures market. The right hedging strategy is the back-to-back hedging strategy. This strategy involves closing any open position immediately by purchasing any respective commodity in the market this way, the commodity risk is minimized. However, it is important to note that the strategy has a volume and liquidity risks.
The back to back hedging strategy is like a margin call because it has low risk even in a volatile market. For example, the share market is expected to decrease in the following week and the market is considerably unstable. Additionally, the rate of share prices decline is very fast that does not allow for other option. The margin call will allow the hedger to minimize risk by liquidating his position in the stock. This mean that the hedger has the option of either liquidating his position or adding more cash into his account. The strategy is more flexible as it allows the hedger to exercise freedom in relation to his account. For example, the hedger can borrow some money from the brokerage firms. This way, he won’t have to have all the funds required to purchase the desired number of securities. For example, the hedger only need a smaller amount in his accounts and borrows the rest. If the value of the securities decline, the equity in his accounts will decline. Assuming that the maintenance requirement is only 70% of the initial margin value of 2$. The customer will have to pay only a smaller amount in equity in his account (70% of 2% of 14milionm)
=196,000. Because the amount of equity in his account is less than the maintenance margin, the brokerage firms will issue a margin call of very low value.
The initial margin requirement in this case was 2%, while the maintenance margin is 70% of the initial margin
Initial margin value
Tenaga Nasional BHD is priced at 14.02 and assuming that the million shares would be 140200000. An initial capital outlay of 2% is required 2,804,000 (0.2% X 140,200,000)
Maintenance margin value
=The maintenance margin of 70% of the initial margin of 2,804,000
The hedger would have to hold1,962,800 in his account if he buys Tenaga Nasional BHD on margin or sell shares short.
Purchasing 10milionTenaga Nasional BHD priced at14.02 mean that the investor wouldreceive a margin call priced at:
The investor will receive a margin call at RM14.
The margin will only be received when the prices of Tenaga Nasional BHD fell below the RM14 mark. Therefore, the investor will have to invest more funds or liquidate all the shares in order to meet the initial margin requirements.
Recommend four (4) possible actions that can be taken by Bursa Malaysia Derivatives Berhad (MDB) and Securities Industry Development Corporation (SIDC) to improve the liquidity of the Malaysian derivatives market.
Because the market is relatively unstable and has low liquidity, the market can about all the trades without having positive prices movements (Angabini and Wasiuzzaman, 2010). The market need to be liquid, which is mainly associated with narrow bid, and ask spreads (Duarte, 2006). To improve the overall market liquidity, the following actions are recommended:
- Improve the level of floats
The free float is the percentage of share capital available for trading in the public equity market. If the free floats adjusted index is increased, the public corporations would be encouraged to absorb meet some free float thresholds (Fischer, 2015). Additionally, the public listed companies as well as the government-linked companies have been encouraged to use warrants and exchange traded funds (Frino, Kruk and Lepone, 2010)
2. Foreign Intermediaries
The Bursa Malaysia Derivatives Berhad (MDB) and Securities Industry Development Corporation (SIDC) should encourage foreign intermediaries would draw more player into the market would drive competition between the local and global players. This would improve checks and balances as well as the overall efficiency in the market, which is also characterized by more liquidity (Hull, 2006).
3. Market Access
Improving market access would also improve the overall liquidity in the market. For example, with technological advantages such as efficiency, the investors can access the derivative market at any time of the day remotely over various gadgets (Kolb, 2000). Technology can also help the Bursa Malaysia Derivatives Berhad (MDB) and Securities Industry Development Corporation (SIDC) to channel global investments flows onto the Malaysian market. Additionally the global institutions and key investors would be able to demand much more control over their assets in the market (Saad, 2013). The participation of more competitive players in the market would mean that the players would have to reconfigure their access, improve the market efficiency, liquidity. It will also add more structures to ensure that market is more organized for both the local dealers and the cross border dealers (Saad, 2013). For example, improving the direct market access, developing a more efficient and interactive open interface technology (API) would improve remote access as can be seen in the major derivatives market across the world. Improving access would increase the pool of retail trader in the market. Retail traders are known for their active participation in the market producing a net effect of efficient, oversight and liquidity (Spence, 1999)
4. Capital Account Liberalization
The liberalization of the derivatives market would improve the capital controls and restrictions. Liberalization can reduce capital controls as it affects the overlap liquidity, outflows of funds as well as inflows of funds. Lifting the capital control would improve the international competitiveness of the derivatives market (Teplova and Rodina, 2016). The domestic shares prices would also improve despite a little more volatility. Improving integration of the local market with the international market would help push local market development faster. The investor would pressurize the domestic intermediaries and retail investors to improve their trading methods, systems, infrastructures and regulations to support all financial instruments. This will also help in improving the flow of capital regionally and internationally. To an extent, it would also help streamline all the regulatory requirements in line with the international market requirements.
Angabini, A. and Wasiuzzaman, S. (2010). Modeling the effects of the global financial crisis on the malaysian market. International Journal of Trade, Economics and Finance, pp.387-391.
Duarte, J. (2006). Futures & options for dummies. Hoboken, NJ: Wiley Pub., Inc.
Fischer, J. (2015). Malaysian diaspora strategies in a globalized Muslim market. Geoforum, 59, pp.169-177.
Frino, A., Kruk, J. and Lepone, A. (2010). Liquidity and transaction costs in the European carbon futures market. J deriv hedge funds, 16(2), pp.100-115.
Hull, J. (2006). Options, futures, and other derivatives. Upper Saddle River, N.J.: Pearson/Prentice Hall.
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Saad, N. (2013). Performance of Crude Palm Oil and Crude Palm Kernel Oil Futures in Malaysian Derivatives Market. Journal of Business & Management, 2(1), pp.26-33.
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