Malaysian Government Securities (MGS) Futures

MGS are fixed income government securities that are traded on the bond market.MGS also called government bonds, are gilt-edge securities as they represent the borrowings of the best name in the country. They are issued by the government to finance long term development projects. The tenure of MGS is normally medium to long term up to 30 years. Coupon payments are made semi-annually.

MGS futures are contracts to make or to take delivery of MGS at a future date. Upon maturity the buyers and sellers of the MGS futures contracts will be settled in cash based on a final settlement value. The potential users of this contract are financial institutions, insurance companies, bond portfolio managers, asset managers, individual including BMD local member.

MGS futures as a temporary substitute for holding physical bonds

The physical bond market can, at times, be rather illiquid i.e little trades done. There are also occasions where the whole issue of the bond is closely held by a single party for investment purposes. As such, investors may at times find it difficult to find the desired bond from the secondary cash market. As an alternative to holding the physical bond, institutional investors may opt to use the 3,5 or 10 year MGS futures contract. The institutional investor could go in to the futures market and buy or long the MGS futures contract until the actual physical bond becomes available. When that happens, the institutional investor would buy the physical bond and simultaneously sell or short the MGS futures that it had earlier bought.

For example, on 1/2/2012, ABC bank needs RM10 million of MGS. However, it also realizes that physical bond market for that day extremely illiquid. As an alternative, ABC bank can buy or long the MGS futures contracts as a temporary substitute.

Contract required= Required bond amount / value of MGS futures contract = RM10,000,000/ RM100,000

= 100 contractsTherefore, ABC bank will buy 100 contracts of the MGS futures for this purpose. Now say, on 17/2/2013, the physical bond becomes available on the secondary market. ABC bank will buy this bond, and at the same time, liquidate the futures contract that it had earlier bought. This is done by selling in the futures market the 100 contracts that it already has. Any price movement during this period, i.e from 1/2/2012 to 17/2/2013, would have been offset by an almost similar price movement on the MGS futures market.

Directional trading

Like any futures market, the role of speculators is much needed to provide liquidity. These are the people that will assume the price risk that hedgers seek to transfer. These speculators are motivated by profits as the market fluctuates. Similarly, the MGS futures contracts will need speculators in the market

to perform effectively. These speculators will form a view of the market and will take positions, be it on the long or short side.

Like other instruments, the bonds are sensitive to market information. Among the information that it would react to would be the news of new issues of bond and the fluctuation of interest rates. If, say there is a new issue, the prices of existing bonds would decline as investors, especially institutional investor would switch between the existing bonds to the newly issued bonds. This is especially so when the yield on the newly issued bond is more attractive than the existing one. Similarly, a reduction or increase in interest rates would move the bond prices. However, it must be noted that bond prices would move adverse to the movement on the interest rates. Thus, if interest rate rise, the bond prices would decline while any reduction in interest rates would attract an upward movement on bond prices.

Example: Now assuming that interest rates are expected to rise in the coming future. As a speculator, this would mean that prices of the bond might decline as a result of this move. The speculator could therefore, go into the MGS futures market and sell the futures contract. Say on 13/3/2012 he sells 10 lots of the June MGS futures at 113.30. The following week, his view that interest rates would rise, materializes. The bond futures prices falls to 113.00. His profits would look like this:

Profit= 10 lots x [ (113.30-113.00) x RM 10.00] = 10 lots x (30 ticks x RM10.00) = RM3000.Now assume that due to falling inflation, the central bank is of the view that the country can afford to have lower interest rates. As a speculator, this would mean a buying opportunity for him in the futures market as a lower interest rate regime could lead to the rise of bond prices. Therefore, he would be buying the MGS futures contracts to capture this profitable opportunity. Say on 21/4/2012 he goes into the MGS futures market to buy 20 lots of June contract at 108.50. He holds it for a while and in between, interest rates does fall, and in turn lead to firmer prices for the bond futures. Say on 13/5/2012 the June futures price is now at 112.00. His profits therefore:

Profit= 20 lots x [ (112.00-108.50) x RM 10.00] =20 lots x (350 ticks x RM10) = RM70,000

HedgingHedgers will seek to transfer the price risk to the market. Investors with long bond portfolio will seek to avoid the risk of any upward movement on the interest rates or decline in bond prices. To do this, it has the option of selling the MGS futures.

Example: Assume now that DEF bank holds RM100 million worth of MGS bonds. According to analyst views, the increase in inflation rates would lead to higher interest rates in the coming months. As such, as an investor with a long bond portfolio, it will have to sell the MGS futures to avoid the risk of falling bond prices. Say the price of the RM100 million bond portfolio is at

115.00 and the September MGS futures is currently at 114.25. To hedge this RM100 million bond portfolio, DEF bank would need

Contract required= RM100million/RM100,000= 1,000 contracts

By selling 1,000 MGS futures contracts, DEF bank would have fully hedged its bond portfolio. Now, say the view that interest rates would rise does take place, and as a consequence of that, the portfolio price falls to 114.00. This is 100 basis points loss on the bond portfolio. Assume also that a similar move too place on the MGS futures market. As a result, the MSG futures price fell to 113.25. If DEF bank had sold the 1000 contracts required, the 100 basis points loss on the bond portfolio would have been offset by the gains made on the MGS futures contracts.