1. © K. Cuthbertson and D. Nitzsche Chapter 24 Futures Markets Investments

2. 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

3. © 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

4. © 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 CME NY Mercantile Exchange,NYMEX Philadelphia Exchange Pacific Stock Exchange NYSE-Euronext (was LIFFE) Singapore, Hong Kong, Tokyo, Osaka Sydney Futures Exchange Figure 2 : Financial futures

5. CommodityDeliveryContractMin. 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)

6. © K. Cuthbertson and D. Nitzsche Futures price Profit per contract $10 -$10 0 Long future Short future F 2 = 110 F 2 = 90 F 1 = 100 Figure 3 : Speculation with futures

7. © K. Cuthbertson and D. Nitzsche Figure 4 : Newspaper quotes - WSJ

8. Stock price S = $100 Risk-free rate r = 4% p.a. Quoted futures price F 90 = $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

9. Stock price S = $100 Risk-free rate r = 16% p.a. Quoted futures price F 90 = $102 Strategy today 3 months time (T = 1/4) Riskless profit = Homework Arbitrage

10. 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 (?)