EXCHANGE TRADED AGRICULTURAL DERIVATIVES IN SOUTH AFRICA

EXCHANGE TRADED AGRICULTURAL DERIVATIVES IN SOUTH AFRICA Contents Introduction What is the Role of Agricultural Derivatives? Why Trade Agricultural Derivatives on an Exchange? How are Agricultural Derivatives Traded? Mark to Mark (M-t-M) Calculation of Futures and Options Settlement Procedures of Agricultural Derivatives What is Physical Delivery? Notice day Delivery day Margin Requirements during the Delivery Month How is Risk Managed? How Can You Use Futures to Hedge Risk? (i) The Short (Selling) Hedge (ii) The Long (Buying) Hedge Basic Option Strategies (i) Buying a Call Option (ii) Buying a Put Option Contract Specifications on the Safex Agricultural Products Division of the JSE Maize Futures Contract Wheat Futures Contract Sunflower Seeds Futures Contract Soybean Futures Contract Glossary Please note: Bold text in italics refers to Glossary of Terms

Introduction Agricultural markets across the world have moved away from government price intervention towards economic based markets. This has been mainly due to the pressure of a globalising world economy as well as failure of costly agricultural subsidy regimes and state controlled agricultural marketing boards. It is now common for smaller commodity markets to form exchanges, either cash or futures, which are playing an integral role in facilitating marketing and ensuring price transparency. Bulgaria, Poland, Romania and Hungary are examples of countries experiencing the same dynamic growth in their commodity markets as South Africa. The demise of agricultural marketing control boards in South Africa during the early 1990 s and extensive liberalisation was the background that stimulated the formation of Safex s Agricultural Markets Division to trade agricultural derivatives. Development of Agricultural Markets Division (AMD) of Safex The Agricultural Markets Division (AMD) was established in January 1995 as a division of the South African Futures Exchange (Safex). AMD quickly established itself as the agricultural market leader with respect to price transparency especially in the maize market in Southern Africa. Since deregulation the maize market has been exposed to numerous market conditions affecting demand and supply including changing weather patterns, currency fluctuations and regional food shortages. The AMD becomes the APD During the first half of 2001, members of Safex accepted a buyout by the JSE Securities Exchange to become a separate division within the JSE. As from August 2001, the Agricultural Markets Division of Safex became the Agricultural Products Division of the JSE Securities Exchange South Africa and moved from its original premises in Houghton to the JSE building in Sandton. Currently, white maize is the most liquid contract followed by wheat, yellow maize, sunflower seeds and soya beans. The growth in the market has resulted from an increased number of participants, greater understanding of the market and the development of a broader base of marketing strategies based on the derivative products. 2007 was another record trading year with regards the total number of contracts traded, just under 5% higher than the previous record in 2003 with 2,4 million contracts traded. What is the Role of Agricultural Derivatives? Agricultural derivatives play an active role in price determination and transparency in the local agricultural market whilst providing an efficient price risk management facility. 1

Producers and users of agricultural commodities hedge their price risk, thereby limiting their exposure to adverse price movements. This encourages increased productivity in the agricultural sector as farmers and users are able to concentrate their efforts on managing production risks. These are the risks associated with variables such as the weather, farm/production management and seasonal conditions. The futures market exists solely for the purpose of allowing commercial users to hedge their transactions or lock in favourable prices. Yet, the market could not operate efficiently and effectively without speculators, as they provide the necessary market liquidity which allows commercial users to hedge. Speculators use futures and options in an attempt to make profits on shortterm price movements. Financial institutions lending to these sectors are also ensured of reduced risk profiles when dealing with clients who have hedged a portion of their price risk. Such clients could typically access funds at cheaper rates than would otherwise have been offered. The agricultural derivatives market has developed to such an extent that the cash market now largely relies on its price transparency and discovery process to function properly. Prices generated on the derivatives market are now considered the industry standard and reference point throughout Southern Africa. Why Trade Agricultural Derivatives on an Exchange? 1. 2. 3. 4. Regulation Safex APD is a division of the JSE managed by the JSE and regulated by the Financial Services Board (FSB) which oversees the exchange s reporting with regards to the Security Services Act of 2004 (SSA) which replaced the Financial Markets Control Act of 1989 and the Stock Exchange Control Act of 1985. Margins - When trading derivative products, the exchange requires the payment of both initial margins and variation margins. The initial margins are determined by the clearing house and vary depending on historical price volatility. The variation margin is a daily flow of funds (profits/losses) resulting from any open position calculated through a methodology of Mark-to-Market (M-t-M). Financial Integrity When dealing with the exchange the exchange s clearing house becomes seller to every buyer and buyer to every seller. Members are free to deal with each other without any credit risk. This eliminates counter party risk which is prevalent in the Over the counter markets (OTC). Transparency Pricing is determined purely on the basis of demand and supply. Prices for each contract are negotiated between buyers and sellers via an electronic order matching platform called the Automated Trading 2

System (ATS). The presence of numerous buyers and sellers ensures that prices are always competitive and adjust efficiently to reflect changes in the underlying market. How are Agricultural Derivatives Traded? Registered agricultural derivative brokers input orders into the ATS from remote locations (during trading hours (09h00 12h00) which are automatically matched on the basis of time and price priority. The exchange guarantees performance by counterparties in a futures contract. Agricultural derivative prices are quoted at their Rand value per ton, delivered on truck alongside silo basis Randfontein. One futures contract comprises 100 tons for white and yellow maize and 50 tons for wheat and sunflower seeds. Soybean contracts are quoted at their Rand value per ton, and comprise 25 tons per contract. The soybean contract trades at the same basis price in a number of registered silos with no location differentials. Daily price limits, limiting the daily movement of prices, add security to the market. If the limit is reached on two like contracts on two consecutive days the price limits are increased to 150% of the original limit and the extended limits will remain in place until the daily movement on all like contracts is less then the original limits. Extended price limits also result in increased initial margin requirements for those periods when the extended limits apply. Futures are quoted on the trading system as: Month of expiry, year of expiry, four letter code of commodity JUL08 WMAZ White maize contract DEC08 YMAZ Yellow maize contract SEP08 WEAT Wheat contract MAR09 SUNS Sunflower seeds contract MAY09 SOYA Soybean contract Mark to Market (M-t-M) Calculation of Futures and Options The Mark-to-Market (m-t-m) for the day, also referred to as the settlement price, is determined at random any time in the last 5 minutes of trading at the discretion of the exchange. If the bid is better than the last traded price the bid will be used as the m-t-m price. (In simple terms this can be interpreted as buyers in the market prepared to pay more than the last traded price). Should the offer be lower than the last traded price then the offer will be used as the m-t-m. (This means that there are sellers in the market who are prepared to sell lower than the last traded price). 3

A volume weighted average price (VWAP) is used to calculate the m-t-m for all liquid contracts. A liquid contract is defined as any expiry that trades 100 or more contracts in the last half hour of trading. The closing option volatility is calculated using the following methodology (notice A757) Options traded over the last hour of the trading session will be considered for the m-t-m process Two strike prices (50 points) either side of the option at the money will be considered eg if at the money strike is 600, then 560, 580 and 620, 640 strikes will be considered in the process If 60 or more contracts have traded for the entire day, the contract will be considered liquid The opposite applies to illiquid contracts, if less than 60 contracts have traded for the entire day then the contract is classified illiquid If classified as liquid, then a volume weighted average of 40 or more contracts will be required in the last hour of trade as the m-t-m volatility, if this quantity does not trade then the volatility will remain unchanged If classified as illiquid, then a volume weighted average of 20 or more contracts will be required in the last hour of trade for the m-t-m volatility, if this quantity does not trade then the volatility will remain unchanged As an exception, where the future contracts trade limit up or down for most of the option m-t-m period, only options traded on the delta option window will be considered for m-t-m volatility purposes No options traded on price through the naked option window will be considered If the number of delta options traded do not meet the liquid or illiquid criteria as described above, the bids and offers on the delta window will be considered as a last resort and at the exchanges discretion The exchange reserves the right to make the final decision regarding the m-t-m volatility and may exercise its discretion as need be. This implied volatility is then used to value all option positions. Settlement Procedures of Agricultural Derivatives What is Physical Delivery? All products traded on the agricultural derivatives market can be physically delivered at expiry in fulfillment of a futures contract. This does not mean that 100 tons of maize is delivered by truck to the exchange to complete the delivery process. The exchange makes use of a silo receipt, a transferable but not negotiable document, representing a specific quantity of stock in a registered Safex silo to effect delivery. Paper and electronic silo receipts issued by registered silo owners is accepted by the exchange. The silo owner storing the product guarantees the quality of stock as per detailed grading methodology specified by the National Department of Agriculture and to outload the specific product upon presentation of the silo receipt. Delivery can take place any business day on a particular delivery month. (A futures position in the July contract can only be delivered on during July). 4

Physical delivery takes place over a two-business day period, the notice day followed by the delivery day (the next business day). Delivery can take place at any Safex approved silo and each delivery point is subject to a location differential (based on transport costs). Location differentials are determined by the exchange and are available on the Safex website.( www.safex.co.za) Notice day The short position holder (seller of the commodity) notifies his broker about his intention to give notice of delivery to close-out a futures position. Notice must be given before 12h45 on any business day during the delivery month. The last notice day being the second last business day of the delivery month. For example a short position holder could give notice on the September futures contract on the 31 August for delivery on the 1 September or his last notice day would be the 29 September for delivery on the 30 September. (For all delivery dates see Agricultural Markets Contract specifications on the web page). The deliveries are randomly allocated by computer programme to existing long position holders. A long position holder allocated stock will be notified through the clearing member of the allocation. (the detailed allocation algorithm is available on the web page under the physical delivery subsection) Any long position holder (buyer of the commodity) could be allocated product at any time during the delivery month with one day s notice but is assured that he will receive such stock by the last day of the delivery month. Buyers are guaranteed that it will be at a registered silo and free along side rail. The best case scenario is being allocated maize in a silo convenient to the buyer however the worse case scenario is Randfontein. Therefore the location differential will always ensure that the basis Randfontein price is traded. The closing price (mark-to-market) on the notice day is the price at which contracts are closed. The location differentials and any outstanding storage is deducted from the amount payable by a long position holder (in the case of wheat a grade discount is also applicable). The exchange does not take any prepaid storage into account and the seller forfeits any storage costs that have been prepaid. Long position holders are charged a standard daily storage rate fixed for each marketing season and are responsible for storage from the delivery day onwards. Delivery day Silo receipts have to be delivered to a broker who will in turn ensure that they reach the exchange no later than 12h00 on the delivery day. Payments for products take place by 12h00 on the delivery day. Long position holders are able to collect silo receipts from the exchange from 14h00 onwards. Positions can still be opened or closed during the delivery month until the last trading day. The last trading day is the eighth last business day of each delivery month. Once the contract has closed for trading any position still 5

open will have to be honored by payment or delivery (short position holders have until the last business day of the delivery month to make delivery). Margin Requirements during the Delivery Month Margin requirements used as a guarantee by the exchange change during the delivery month. Current margin requirements can be obtained from the exchange. On the first notice day the daily price limits are removed to allow the alignment of the futures value to the value of the underlying product and initial margin is increased to cover the increased risk. After the last trading day initial margin is increased again. In the same way, all long position holders have to take delivery once they are assigned. All futures positions are converted to physical positions which are not marked-to-market on a daily basis. Since the risk increases, the initial margin requirement is increased accordingly in the same fashion as the short position holder. How is Risk Managed? Delivery and settlement on any exchange traded derivative contract is always one hundred percent guaranteed. This is done through the novation process whereby the clearing house assumes the position of buyer to every seller and seller to every buyer. The counterparties do not deal with each other directly as the exchange matches all long and short positions. To manage default risk, the exchange uses its three-tier system, initial margin requirements as well as the daily m-t-m process. Should a client default on a contract, his broker assumes these positions. The broker could then close them off and use the initial margin deposit held to cover his losses. In the event that the broker is unable to assume the client s positions, his clearing member would stand in for him. Currently the clearing members consists of South Africa s largest financial institutions. This tier system ensures that the client on the other side is always guaranteed fulfillment of his position. * How Can You Use Futures to Hedge Risk? (i) The Short (Selling) Hedge Used by producers concerned that a downturn in the spot market price will occur during the growing season, resulting in a lower price for their produce than the present level in the market. To hedge half of an expected 2000 tons of maize, a producer would sell 10 futures contracts (1000 tons divided by contract size of 100 tons). * Please note that all examples used are only meant to help you understand the fundamentals of futures and options trading. They are not meant as investment advice, and as you can see, there is risk of loss. Also, commissions and fees were left out for simplicity s sake. Furthermore, the option prices quoted in the above examples may or may not be executable at the levels cited depending on market conditions prevailing at the specific time of execution. 6

November July (following year) Results Physical Market Futures Market Producer is concerned Producer sells July that Maize will be sold in Maize futures at July at a low price. prevailing futures price Maize price falls. If the producers sells maize in the market he will realise R1700/ton. The producer receives the discounted spot price (R1700/ton) for the whole crop. of R1900/ton July Maize futures fall to R1700/ton in line with the spot market. The producer buys back the future at R1700/ton, resulting in a R200/ton gain from the futures market. The R200/ton gain only applies to the hedged portion (1000 tons). The producer effectively receives R1900/ton the price at which the hedge was made (R1700/ton plus R200/ton futures gain) for the 1000 tons hedged. If the spot market had increased by R100/ton, rather than decreased, a loss would have been incurred on the futures transaction while the producer would receive a higher price on the spot transaction. While it is important to hedge, most producers only buy a partial hedge by means of futures contracts so that they have some exposure to possible favourable price movements but have reasonable protection from unfavourable changes in the market. (ii) The Long (Buying) Hedge This would be an appropriate strategy for a user of maize (e.g. miller). In August a miller decides to take advantage of a historically low maize price by hedging his planned November purchases. August Physical Market Miller needs to purchase Maize in November and wishes to be protected against rising prices. Maize price has risen by R100/ton. The miller buys maize at R700/ton resulting in a R100 notional loss. Futures Market Miller buys November Maize futures contract at R600/ton. November November futures have risen in line with the spot market to R700/ton. The miller sells back the futures contracts at the higher price. Results The miller pays The R100/ton gain from 7

R700/ton for the physical stock in November due to the price increase. the sale of the futures position offsets the increased price of the physical product and the miller effectively pays R600/t for the maize. Basic Option Strategies (i) Buying a Call Option One way that a user of a traded product can obtain protection against adverse commodity price exposure via the options market is to buy a call option. In our example we will look at the purchase of a July White Maize 800 call option. In effect, a call option gives the buyer of the option the right, but not the obligation, to buy the underlying commodity at a pre-determined price, called the strike price, for a fixed period of time. The cost of this right or benefit is the premium, which is paid by the option buyer to the option seller (writer). The premium is paid and received over the life of the option through the daily process of m-t-m discussed previously. This premium, which is determined by the market on the ATS depends on market conditions such as volatility of the market, time to expiration, market direction, and the supply and demand for options in general. The cost of an option to the option buyer is limited to the premium paid for the option. The option seller is margined by the exchange to ensure that in the event of the option being exercised, the option seller will indeed be in a position to meet the obligations of the option and sell the product to the option buyer at the strike price. The APD trades American style options that can be exercised at any time. Options that expire in-the-money are automatically exercised by the exchange. Options that expire at-the-money (where the closing futures price is exactly at the level of the strike price) will not be exercised by the exchange. Options that expire out-the-money, in other words, which have no value, will expire worthless. There are three ways to exit an option position: Offset: This is done by selling back the option that you previously bought on the exchange. This may or may not result in a profit, depending on the level of premium paid for the option as against the level of premium for which the option is sold. Exercise: An option buyer decides whether to exercise an option or hold it to maturity. He might find it optimal to exercise the option before expiry if the futures market is trading higher than the strike price of the call option that he purchased and there is a possibility that the price may decrease in the future. When an option is exercised, both the buyer and seller are assigned opposite futures positions on a random basis. 8

Expiration: If the option is out-the-money the option holder could let it expire worthless by simply doing nothing. The maximum cost for the buyer is the premium paid for the option. An option buyer will usually not exercise a call option if the futures market is trading below the strike price of the option. Example: Buy 100 July 800 WM1 calls for 15 R/ton (R1500 per contract or R150,000 total). The seller of the July 800 call is obliged to sell July White Maize futures at 800 R/ton at any time during the life of the option no matter how high the price is actually trading in the futures market. In return for this obligation the seller of the option will receive a premium which he keeps no matter what happens in the underlying futures market. (ii) Buying a Put Option One way that a producer can protect against an adverse price movement is to purchase a put option. A put option gives the option buyer the right, but not the obligation to sell the underlying commodity at a fixed price for a fixed period of time. The price for this flexibility is the premium paid by the put option buyer and received by the seller over the course of the mark-to-market process. This premium depends on market conditions such as market volatility, time to option expiration, market direction and the supply and demand for options in general Regardless of market fluctuations, the maximum loss an option buyer can sustain is the premium paid for the put option. Because of this limited and known risk, buyers of options are never faced with additional margin calls. As discussed previously there are three ways to exit an option position; offset, exercise and option expiration. Example: Buy 100 July 760 WM1 put options for 40 R/ton (R4000 per contract or R400,000 total). This gives the put option buyer the right, but not the obligation, to sell 100 July WM1 futures contracts at R760/ton until June 24, 1998. The cost for this is 40 R/ton. Contract Specifications Maize Futures Contract (White & Yellow Maize) Specifications Code Underlying Commodity WMAZ/YMAZ Maize means white/yellow maize from any 9

Trading Hours Contract Size Contract Months Expiration Date and Time Settlement Method Quotations Minimum Price Movements Initial Margin Expiry Valuation Method Booking Fees Charges Maximum Daily Price Movement Maximum Position limits origin, of the grade WM1 ( YM1 ) as defined in the South African Grading regulations, that meets all phyto-sanitary requirements and import regulations, but is not subject to the containment conditions for the importation of genetically modified organisms 09h00-12h00 100 Metric Tons March, May, July, September, December All other calendar months are introduced 20 business days preceding the new month. Once the month is introduced it is traded in the same fashion as the 5 hedging months. 12h00 on the eighth last business day of the listed expiry month. Physical deliveries from the first business day to the last business day of expiry month. Physical delivery of Safex silo receipts giving title to maize in bulk storage at approved silos at an agreed storage rate. Rands/ton. Twenty cents per ton. WM1 R10 000/contract up to first notice day. At extended price limits, requirements increased to R13 000/contract R13 000/contract up to expiry day. R23 000/contract up to last delivery day. R2 000/contract for calendar spreads. R2 250/contract for white spreads. YM1 R10 000/contract up to first notice day. At extended price limits, requirements increased to R13 000/contract R13 000/contract up to expiry day. R23 000/contract up to last delivery day. R2 000/contract for calendar spreads. R2 250/contract for yellow spreads. Closing futures price as determined by the clearing house. Futures: R12.00/contract (incl VAT). Options: R6.00/contract (incl VAT). Physical delivery: R200.00/contract (incl VAT). R45/ton (R65/ton at extended limits) Position limits apply to White Maize as per Derivative Directives Wheat Futures Contract Specifications 10

Code Underlying Commodity Trading Hours Contract Size Expiration Date and Time Settlement Method Quotations Minimum Price Movements WEAT bread milling wheat originating in South Africa, Argentina, No 2 US Dark Northern Spring wheat, No 2 Hard Red Winter wheat, No 3 Canadian Red Western Spring wheat, Australian Hard wheat, Australian Prime Hard wheat and Australian Premium White wheat of sound, fair and merchantable quality which is fit for human consumption and which complies with the listed criteria and the requirements and methodology as contained in the SOUTH AFRICAN RULES FOR THE CLASSIFICATION AND GRADING OF WHEAT. Discounts will apply to grades B2 and B3 and an additional discount will apply to all wheat of imported origin. Applicable from 01/10/08 30/9/09: Bead milling wheat originating in South Africa, Argentina, USA Hard Red Spring (DNS & NSW), USA Hard Red Winter, no 3 or better Canadian Red Western Spring wheat, Australian Hard wheat, Australian Prime Hard, Australian Prime White, Australian Standard White wheat and German Type A or B wheat of sound, fair and merchantable quality which is fit for human consumption and which complies with the listed criteria and the requirements and methodology as contained in the SOUTH AFRICAN RULES FOR THE CLASSIFICATION AND GRADING OF WHEAT. Discounts will apply to grades B2 and B3 with a varying origin discount defined in notice A852, for any foreign wheat from the above origins. 09h00-12h00 50 Metric Tons 12h00 on the eighth last business day of listed expiry month. Physical deliveries from the first business day to the last business day of expiry month. All other calendar months are introduced 20 business days preceding the new month. Once the month is introduced it is traded in the same fashion as the 5 hedging months. Physical delivery of Safex silo receipts giving title to wheat in bulk storage at approved silos at an agreed storage rate. Rands/ton. Twenty cents per ton. 11

Initial Margin Expiry Valuation Method Booking Fees Charges Maximum Daily Price Movement Origin Discount R7 000/contract up to the first notice day. At extended price limits, requirements increased to R9 500/contract R9 500/contract up to the last expiry day. R19 000/contract up to the last delivery day. R2 100/contract for calendar spreads. Closing futures price as determined by the Clearing House. Futures: R6.00/contract (incl VAT). Options: R3.00/contract (incl VAT). Physical delivery: R100.00/contract (incl VAT). R65/ton (extended limits = R95/ton) Currently R100/ton, from 1 Oct 08 the following origins acceptable for delivery at a ZERO origin discount: USA Hard Red Spring (Dark Northern Spring and Northern Spring wheat), No 3 or better Canadian Red Western Spring wheat, Australian Hard, Australian Prime Hard, Australian Prime White and Australian Standard White wheat and Wheat from the following origins acceptable for delivery at a R100 per ton discount: Argentina, USA Hard Red Winter wheat and German Type A or B wheat Sunflower Seeds Futures Contract Specifications Code Underlying Commodity Trading Hours Contract Size Expiration Date and Time Settlement Method Quotations Minimum Price Movements SUNS FH South African Origin high oil content Sunflower seeds meeting specified criteria. 09h00-12h00 50 Metric Tons 12h00 on the eighth last business day of listed expiry month. Physical deliveries from the first business day to the last day of expiry month. All other calendar months are introduced 20 business days preceding the new month. Once the month is introduced it is traded in the same fashion as the 5 hedging months. Physical delivery of Safex silo receipts giving title to sunflower seed in bulk storage at approved silos at an agreed storage rate. Rands/ton. One Rand per ton. 12

Initial Margin Expiry Valuation Method Booking Fees Charges Maximum Daily Price Movement Maximum Position Limits R9 500/contract up to the first notice day At extended price limits, requirements increased to R12 500/contract R12 500/contract up to expiry day. R25 000/contract up to the last delivery day. R2 850/contract for calendar spreads. Closing futures price as determined by the Clearing House. Futures: R6.00/contract (incl VAT). Options: R3.00/contract (incl VAT). Physical delivery: R100.00/contract (incl VAT) R90/ton. (extended limits = R135/ton) 1000 contracts within 10 days of expiry month. Soybean Futures Contract Specifications Code Underlying Commodity Trading Hours Contract Size Expiration Date & Time Settlement Method Quotations Minimum Price Movement Initial Margin Expiry Valuation Method Booking Fees charges Maximum Daily Price Movements Maximum Position Limits SOYA Soybeans of Class SB as defined in the South African grading regulations of the Agricultural Products Standards Act of 1990. Soybeans of any origin will be deliverable as long as the product conforms to the above SB grade. 09h00-12h00 25 metric tons 12:00 on the eight last business day of the listed expiry month. Physical deliveries from first business day to last business day of expiry month. Physical delivery of Safex silo receipts giving title to soybeans in bulk storage at approved silos at an agreed storage rate. Rand/ton Twenty cents per ton R3750/contract up to first notice day. At extended price limits, requirements increased to R5 000/contract R5000/contract up to expiry day. R10 000/contract up to last delivery day. R1 200/contract for calendar spreads. Closing futures price as determined by the Clearing House Futures: R3.00/contract (incl VAT). Options: R1.50/contract (incl VAT). Physical delivery: R50.00/contract (incl VAT) R50/ton. (extended limits = R75/ton) 800 contracts within 10 days of expiry month. 13

American style option contracts are available on all the above futures contracts for trading months March, May, July, September and December. Glossary of Terms Arbitrage Trading strategies designed to profit from price differences for the same or similar goods in different markets. Ask price (see Offer price) At-the-money An option is at-the-money if the strike price of the option is equal to the market price of the underlying asset. Bid price The quoted price at which a particular market dealer is willing to buy. Call Option An option contract that gives the holder the right, but not the obligation, to buy the underlying asset at a specified price (strike price) for a certain fixed period of time. The seller of a call option is obliged to deliver the underlying asset at the strike price. Clearing The settlement of a transaction, often involving exchange of payments and/or documentation. Clearing House An organisation, legally separate from the Exchange, which clears transactions and guarantees all trades (see novation ). Delta A measure of how much an option premium changes given a unit change in the price of the underlying. Derivative A financial security whose value is determined, in part, from the value and characteristics of an underlying asset e.g. futures, options (both exchange traded and OTC). Exercise Implementation of the right under which the holder of an option is entitled to buy (in the case of a call) or sell (in the case of a put) the underlying asset. Exercise price (see strike price) Expiry, expiration date, maturity date Date and time upon which an option or future, and the right to exercise them, ceases to exist. Most commonly used to describe when the buyer / holder of 14

an option ceases to have any rights under the contract, or when a futures contract month ceases trading. Hedge A conservative strategy used to limit price losses by effecting a transaction that protects an existing position. Dealing in such a manner as to reduce risk by taking a position that offsets an existing or anticipated exposure to a change in market prices. In-the-money A call option is in-the-money if the strike price is less than the market price of the underlying asset. A put option is in-the-money if the strike price is greater than the market price of the underlying asset. Initial Margin A good faith deposit which both buyer and seller must lodge with the clearinghouse as security. Intrinsic value The amount by which an option is in-the-money (see above definition). Location Differential This is the indicative cost of transporting stock from any Safex registered silo to Randfontein. The traded price is always referred to as a Randfontein price while the price the buyer pays will be reduced by the cost differential to Randfontein of the silo he was allocated. Long position An investor has a long position when contracts are purchased. Margin (or Variation Margin) The cash payment that is required to maintain an initial margin position. This is determined daily by the Exchange via a process of mark-to-market. Margin requirement (for options) The amount an uncovered option writer (seller) is required to deposit and maintain to cover a position. The margin requirement is calculated daily. Mark-to-market (MTM) The revaluation of a futures or options position at its current market price. All positions are marked-to-market by the clearinghouse, once a day. The profit/loss that is revealed by the re-valuation is received by or paid to the clearinghouse (known as variation margin). Novation The guaranteeing responsibility of a clearing house upon successful matching of a trade. The clearinghouse is substituted as the seller to every buyer and buyer to every seller on a principal to principal basis. 15

Offer price (or Ask price) The quoted price at which a particular market trader is willing to sell. Out-of-the-money A call option is out-of-the-money if the strike price is greater than the market price of the underlying asset. A put option is out-of-the-money if the strike price is less than the market price of the underlying asset. Over the counter (OTC) Term used to describe trading in financial instruments off organised exchanges with the risk that performance by the counterparties is not guaranteed by an exchange. Physical (spot/cash) market The current market in the underlying asset for immediate delivery. Premium The fair value of an option contract, determined in the competitive marketplace, which the buyer of the option pays to the option writer for the rights conveyed by the option contract. Put option An option contract that gives the holder the right, but not the obligation, to sell the underlying asset at a specified price for a certain fixed period of time. The seller of a put option is obliged to take delivery of the underlying security at the put strike price. Physical delivery Safex makes use of a Safex silo receipt for physical delivery in completion of a futures contract. The silo receipt represents the specific quantity of stock in a registered Safex silo. The silo owner who stores the product guarantees the quality and quantity of the stock. Risk management The science of assessing and controlling risks with the aim of keeping them within acceptable bounds. Short position Selling a derivative when one does not own the physical security but intends supplying the physical security upon expiry of the contract. Silo receipt A transferable, but not negotiable document that represents title to a specific quantity, of a specified quality free alongside rail at a registered Safex silo. Spot market See physical market 16

Strike price The agreed price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Tick The smallest change in price movement of a contract permitted by the Exchange. (See contract specifications for each contracts tick). Time value The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option is worth in addition to its intrinsic value. Type The classification of an option contract as either a put or a call. Underlying asset The physical asset upon which a derivative contract is based (see also Physical). Variation Margin (see marking-to-market) Volatility A measure of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns. Writer The seller of an option contract. 17