Financial Journalist

Benchmark — Investment Funds of Asia First Quarter 1999
By Gerry O’Kane

It is a financial instrument often mentioned but that few understand, including many of the professionals. This complex derivative is the instrument that destroyed Barings Bank.

That is the bad publicity. The reality is that futures and its sister, options, are frequently used by fund managers to hedge their positions; to protect themselves from the market doing something completely unexpected or as a way to trade more cheaply in an illiquid market. All that comes later.

What is a futures contract and how does it work? Put simply futures are an obligation to buy or sell something on a specific day for a preset price. A futures contract can be drawn up on a single stock, a commodity such as oil, or a basket of stocks, usually reflecting the composition of an index. Fund managers usually use futures contracts based on an index, although not always.

Options are the right to buy or sell an item for a preset price during a specified period of time.

Since the collapse of the Asian markets several index futures have come to market. On September 7, the SiMSCI futures contract was launched based on the Morgan Stanley Singapore index. Then on November 2, a new Dow Jones Thailand Stock Index (DJTI) future came to the Singapore International Monetary Exchange (SIMEX). Both contracts are theoretically a valuable tool for fund managers to hedge their equity positions in either Singapore or Thailand, either gaining or reducing their market exposure.

Long or short?
Fund managers can either long a future (enter a contract to buy) or short a future (agreeing to sell). So how does the fund manager use the futures? Firstly, futures contracts initially cost only a small percent of the value of the underlying stocks. The seller of the future undertakes on the settlement date, usually around 30 days, to pay the cash value of the underlying stocks or provide the scrip for the stock. The future can be traded each day, its price moving with the market or expectations. Because of the higher risk with futures, the contract price is more volatile.

A fund manager may be holding stocks due to the fund’s principles of incorporation but he thinks the market is going to fall. He decides to short a futures contact. The fund is holding stock worth US$50 million. He shorts futures worth an equivalent value, the buyer expecting the index to appreciate. The portfolio falls in value by five per cent over the month, realising a paper loss of US$2.5 million. Because of the leveraged and volatile nature of futures, the contracts rise eight per cent. The fund manager is happy since the person who bought his futures contract is obliged to buy but despite a loss in his own stock values, he realises a profit of about US$1.5 million (US$4.0 million futures profit minus US$2.5 million stock loss.)

Trouble With Futures
The trouble with all of this is that despite efforts to reduce risk the use of futures can actually increase it if they are not implemented with pinpoint accuracy. As Salomons (an investment bank) reported, both the SiMSCI and the DJTI futures do not fully represent the underlying indices of Thailand or Singapore. There is some deviation so fund managers have to compute an even more complex method to fully cover themselves. Another problem is that the DJTI, for example, is valued in US dollars, not baht, so currency considerations have to be taken into account.

Options work in a similar yet converse way. A fund manager might be bullish on an index. He would buy a call option; that gives him the right to buy the contract at the strike price at any time during the period of the option. So the person selling may think the index will fall before the end of the month. The fund manager pays him 10% of the value of the contract and waits. The index might rise two points above the level of the seller’s options, if he exercises his option the seller has provide the underlying stock or the equivalent amount of cash. The benefit is a low outlay of cash but making a sizeable profit. Under this method, the buyer does not have to exercise his call but will lose the initial 10% charge.

As one can see, it is a complex and risky business and not for the feint-hearted. That’s why it’s probably best to let fund managers do the shouting. One way to play the market is throguh a specialist fund such as the ED&F Man AHL Diversified Futures fund. The minimum investment is US$30,000 and its track record is good. If you don’t have thirty grand to spend it would be worth going through a reputable financial advisor, they may deal you in with a smaller amount by clubbing your investment together through a nominee account.

Futures and Options