This chapter consists of six sections. The first section is about the background of Malaysian crude palm oil futures. Second section is to describe the contribution of palm oil industry toward Malaysian economy growth. Third section addresses the issues of Malaysian crude palm oil futures. Inventory of palm oil is considerably high and the futures price is falling always. Research question also presented in the same section and it has to be studied to describe the structure of Malaysian crude palm oil futures market. Objectives to carry out this study are presented in the forth section. In fifth section, we provide the significance of study. Last section is about the organization of following chapters of this thesis.
1.1 Pros and Cons of Futures Contract
In Malaysia, palm oil and other commodities are traded in futures market. The purpose of futures market is to allow investors to hedge against risks because unpredictable events such as heavy rainfalls will damage the oil palm production. Buyers and sellers carry out futures transactions or activities through brokers at organized exchange. Malaysian crude palm oil futures contracts are traded at Bursa Malaysia Derivatives Berhad (BMD). The size of crude palm oil futures contract is 25 metric tons and contract expires at noon on the 15th day of the delivery month, or if the 15th is a non-market day, the preceding Business Day.
Trading palm oil through futures contracts allows investors to have time for making prediction about the price in future. Unlike futures contract, forward contract is not appropriate for trading commodity products because all transactions have to be done on the spot. Due to the presence of price risk, the use of futures contracts will bind the buyers and sellers legally. Thus, possibility of breaching the agreement is low. This is because every party has to follow the strike price and other conditions specified in contracts, regardless future market spot rate turns out to against their expectations.
Another advantage of futures market is it has lower default or credit risk than underlying market. To trade in futures market, investors need margin account with specified amount of money or asset to be deposited in it. This helps to lower down the credit risk among the market participants. Credit risk is lower in the sense that any default investors will not get back the money from their margin accounts. Also, futures market is conducted on marked-to-market basis. Gains and losses will be added and deducted in margin account on daily basis.
However, trading via futures contracts may be risky due to the leverage effect which enlarges both gains and losses. When losses are enlarged, futures contract holders will lose a large portion of money and they have to top up their margin deposits in short time. Otherwise, their margin account will be closed. To new infant market players, initial margin can be very expensive to them.
1.2 Relationship between Return and Trading Volume
Investing in either spot market or futures market is accompanied by a variety of risk. Due to the problem of asymmetric information, financial markets are not perfect and efficient. According to Fama (1970), markets are efficient only if current security price is able to reflect all available information. The level of market efficiency can be classified into weak, semi-strong and strong form. Weak form efficiency indicates that a security price trend is already reflecting all the past available information. If the security price adjusts in accordance with the publicly made available information, then the market is considered to be semi-strong form efficient. Strong form efficiency is the most extreme case in which all information, both private and public, is reflected by security price itself.
Asymmetric information problem exists because all market participants are having heterogeneous behaviour. Therefore, technical analysis is conducted to generate information based on financial data. Technical analysts treat historical records as future indicator. However, uninformed or unprofessional market investors prefer to go for fundamental analysis only as they believe that full information can be extracted from the financial reports. Many studies have shown that trading volume can be used together with price or return to predict the price movement in future. According to Beaver (1968), “an important distinction between price and volume tests is that the former reflects changes in the expectations of the market as a whole while the latter reflects changes in the expectations of individual investors.â€
Information transmission between price and volume can be described by four hypotheses, namely mixture of distribution, sequential informational arrival, noise trading, and tax or non-tax related motive trading. Each hypothesis is formed based on the controversial findings of price-volume relationship and trading behaviour that results in market imperfection. By studying return-volume relationship, investors are able to understand how new information is usually disseminated in a particular market. This allows investors to form effective hedging strategies and predict when the market will go bullish from bearish.
1.3 Advantages of Palm Oil
According to Yusof et al (2004), palm oil has many advantages. First, palm oil lengthens the shelf-life of final products due to its resistance to oxidation and therefore it is widely used in food applications. Second, palm oil is an ideal ingredient for producing shortenings and margarines, healthy cooking and salad oils, and other emulsion-based powdered and consumer foods. Third, palm oil can also be used to produce soaps, pharmaceutical products, cosmetics and other oleochemical products. Fourth, palm oil is also a substitute for tallow and coconut oils in the non food sectors since their fatty acid compositions are similar. Fifth, palm oil is also an environmental friendly fuel that can be considered as a renewable back-up once fossil fuel has been used up fully in future.
In terms of human health, Obahiagbon (2012) stated that nutrients in palm oil such as vitamin A and vitamin E are helpful to human metabolic processes, growth and development, and in visual processes. Besides that, palm oil was found in capable of preventing crop-eating insects. Next, red palm oil was effective to be used for treating vitamin A deficiency. Obahiagbon mentioned that nursing mothers were recommended to consume red palm oil in order to gain sufficient vitamin A. The vitamin E from palm oil also has several advantages to human health. For example, one of the components in vitamin E could inhibit breast cancer cells. The vitamin E has antioxidant effect that protects cells from oxidative damaging in physiological system. In addition, vitamin E in palm oil helps to reduce and stop cholesterol synthesis in human body. Palm sap or wine was found to contain rich phytonutrients that can be used for curing malaria, measles, jaundice and the flow of breast milk in nursing mothers.
1.4 Palm Oil History in Malaysia
Malaysia is a well-known producer and supplier of palm oil in the world after Indonesia. It is known that oil palm was introduced by the British to Malaysia. The first plantation was carried out in Tennamaram Estate, Selangor. Since then, Malaysia has gradually become a place that yields high rate of palm oil. According to Fadli et al (2011), many engineers and business graduates that majored in agricultural and agro-industries were trained when it comes to 1970s. This was done to generate experts for conducting more research particularly on oil palm. During 1970s until 1980, high export tax rate was imposed on crude palm oil by Malaysian government in the purpose of enhancing profit in refinery sector. As a result, profits were made since the price of crude palm oil dropped considerably and production of crude palm oil increased. Crude palm oil was then processed to produce various final products and exported them to foreign countries, especially Western Europe at that time.
In 1980s, there was news distributed by American Soybean Association (ASA) about the danger of consuming palm oil to human health and this had severely affected the demand for palm oil. To cope with this problem, Malaysia had to carry out scientific research in order to find new markets and to prove there were no side effects from consuming palm oil. During 1990s until 2000, the world palm oil production increased from 11.0 million tonnes to 21.8 million tonnes. Malaysia produced 10.8 million tonnes of palm oil and this amount accounted for almost half of the palm oil production from entire world. Palm oil has become the largest contributor that supports Malaysian economy and palm oil plantation has accounted for 67 per cent of the land. A merger was made in 2006, where Sime Darby Berhad, Golden Hope Plantations Berhad and Kumpulan Guthrie Berhad were merged together as the government aimed to create the largest oil palm plantation. It turned out the merger was a success as global production of palm oil increased by 5% in 2006. In 2009, palm oil industry was reported to have created jobs for 570000 people.
As reported by Malaysia Palm Oil Council (MPOC), Malaysia now accounts for 39 per cent of world palm oil production and 44 per cent of world export. Palm oil industry has not only supported Malaysian economy, it also helps to create jobs and improve living standard. Therefore, the value of crude palm oil has been recognized since it is the most successful agricultural commodity that can meet various global demands. For instance, palm oil can be the alternative for natural fuels or oils, source of foods and nutrients supplier. Now, crude palm oil is most traded edible oil in Bursa Malaysia Derivative, due to its current and future potential benefits that attract market investors.
1.5 Problem Statement
Investors will face difficulty to hedge against price risk in palm oil market since price movement depends on changes in demand and supply. Market participants will use futures contract to reduce risk, where this contract functions as price discovery and transmits risk to risk-lover parties. It is important to understand the information transmission between return and volume since it implies the degree of informational efficiency in a market. If there is high informational efficiency, prediction about market return in future will become easier. Hence, market participants are able to form proper hedging strategy and allocate their resources with the help from return-volume relationship.
1.6 Objectives
First, we attempt to determine the causality in variance between return and trading volume. This causality can be either unidirectional or bidirectional. If there is a causality of both series, the market is considered as inefficient. In terms of liquidity, market is liquid if there is a bidirectional causal effect between return and volume.
Second, we intend to identify the rate of information arrival in Malaysia crude palm oil futures market. This is helpful when making prediction about the change in either future return or future volume. The rate of information arrival can be determined by observing significant lags based on causal effect in variance movement.
Third, we attempt to identify hypothesis that is suitable to explain the information flow in Malaysian crude palm oil futures market. We want to know whether the price and volume will change simultaneously or sequentially when new information arrives. The right hypothesis can help market participants to make decision in selecting short or long position.
1.7 Significance of Study
The outcomes of our study are expected to provide understanding about behaviour of price-volume dynamic relationship for investors in terms of risk management. Since investing in futures market is a risky bet about the future, wrong hedging strategy will incur huge loss to market participants. Therefore, managing risk based on return-volume relationship allows market participants to short or long the amount futures contracts appropriately and effectively.
For academicians, our study is expected to provide better explanation about information transmission between return and trading volume in futures market. This is because there are not many studies have been done on futures market. Researchers in future can also refer to our study as guidance for further investigation or to conduct different studies on different market.
Moreover, we expect our study to allow investors to predict the time for trading when market is bullish and bearish. For example, we find causal effect runs from volume to return, then investors can focus on volume trend to predict the price movement and return in future. Then, investors can also estimate the right time to buy at low price and sell at high price in Malaysian crude palm oil futures market.
1.8 Study Layout
After we explain the background of our scope, problem statement, objective and significance of study in this chapter, we will organize our thesis into other four chapters:
In chapter 2, we review the literature that is related to price-volume relationship. Based on past findings, we categorize and synthesize the findings in terms of causality, correlation and information flow hypotheses.
In chapter 3,
In chapter 4,
In chapter 5, we summarize all the findings and a conclusion is made.
