© K. Cuthbertson and D. Nitzsche

Chapter 24

Futures MarketsInvestments

Derivatives

© K. Cuthbertson and D. Nitzsche

Derivatives in finance are used to hedge risk; derive their value from the volatility of the underlying asset price (higher volatility = higher value); also called contingent claims, i. e. value is contingent on the price of an asset. Options Futures Forward Swaps

© K. Cuthbertson and D. Nitzsche

OVER-THE-COUNTER

• Supplied by intermediaries (banks)• Customised to suit buyer• Can be done for any amount, any settlement date• Credit risk of counterparty and expensive to unwind• Allows anonymity - important for large deals• New contracts do not need approval of regulator

EXCHANGE TRADED

• Traded on exchanges (e.g. NYSE-EuroNext, CBOT, IMM-CME)• Available for restricted set of assets• Fixed contract sizes and settlement dates• Easy to reverse the position• Credit risk eliminated by clearing house margining system (‘marking to market’)

Figure 1 : Derivative markets

© K. Cuthbertson and D. Nitzsche

INSTRUMENTS

• Money Market Instruments 3 month Eurodollar deposit, 90 day US T-bills, 3 month Sterling or Euro deposits

• Bonds US T-bond, German Bund, UK gilts

• Stock Indices S&P500, FTSE100

• Currencies Euro, Sterling, Yen, etc.

• Mortgage Pools (GNMA)

EXCHANGES

CBOT CMENY Mercantile Exchange,NYMEXPhiladelphia Exchange Pacific Stock Exchange

NYSE-Euronext (was LIFFE)

Singapore, Hong Kong,

Tokyo, Osaka

Sydney Futures Exchange

Figure 2 : Financial futures

Commodity Delivery Contract Min. price change

Daily limit

1.) US T-bonds

(CBOT)

March, June, Sept., Dec.

$ 100,000(8% coupon bond)

$ 31.25(=1/32 of 1%)

$ 2,000 (= 2%)

2.) £-Sterling(CME-IMM)

Jan., March, April. June, July, Sept., Oct., Dec.

£ 125,000 $ 6.25 (= ½ tick)

None

3.) S&P500(CBOT)

Next 4 months and March, June, Sept., Dec.

$250 x (S&P500)

10 points(0.1) = $ 25

None

Figure 1 : Futures (contract specifications)

© K. Cuthbertson and D. Nitzsche

Futures price

Profit per contract

$10

-$10

0

Long future

Short future

F2 = 110

F2 = 90

F 1 =

10

0

Figure 3 : Speculation with futures

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Figure 4 : Newspaper quotes - WSJ

Stock price S = $100Risk-free rate r = 4% p.a.Quoted futures price F90 = $102

Strategy today Sell futures contract at $102 (receive nothing today) Borrow $100, buy stock (= synthetic future) Use no ‘own funds’

3 months time (T = 1/4) Loan outstanding = $100 (1+0.04/4) = $101 Deliver stocks, receipt from futures contract = $102 Riskless profit = $1

Figure 5 : Arbitrage

Stock price S = $100Risk-free rate r = 16% p.a.Quoted futures price F90 = $102

Strategy today

3 months time (T = 1/4) Riskless profit =

Homework Arbitrage

Commodity Futures (carrying cost)

© K. Cuthbertson and D. Nitzsche

F=S + carrying cost (non-arbitrage pricing)F>S + carrying cost (buy spot; sell Futures

=riskless arbitrage)F<S + carrying cost (?)