INTRODUCTION

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. a