Figures for Chapter 2

FUTURES MARKETS
(Financial Engineering : Derivatives and Risk Management)

K. Cuthbertson and D. Nitzsche

Figure 2.1 : Types of derivative markets

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. LIFFE, CBOT, 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)

K. Cuthbertson and D. Nitzsche

Figure 2.2 : Financial futures markets

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

EXCHANGES
CBOT CME NY Futures Exchange Philadelphia Exchange (PHLX) Pacific Stock Exchange (PSE) LIFFE (London) MATIF (Paris) Eurex (Frankfurt) Singapore (SIMEX), Hong Kong, Tokyo, Osaka Sydney Futures Exchange (SFE)

Bonds
US T-bond, German Bund

Stock Indices
S&P500, FTSE100

Currencies
Euro, Sterling, Yen, etc.

Mortgage Pools (GNMA)

K. Cuthbertson and D. Nitzsche

Figure 2.3 : Speculation with futures

Profit per contract
Long future $10
F2 = 90

F1 = 100

F2 = 110

Futures price

-$10

Short future

K. Cuthbertson and D. Nitzsche

Figure 2.4 : Profit payoff (direction vectors)

Profit
10

Profit

+1

-1

10

100

110

90

100

+1 Long Futures or Long Spot

K. Cuthbertson and D. Nitzsche

-1 Short Futures or Short Spot

Figure 2.6 : Arbitrage with futures

Stock price S = $100 Safe rate r = 4% p.a. Quoted futures price F = $102 Strategy today
Sell futures contract at $102 (receive nothing today) Borrow $100, but stock (= synthetic future) Use no own funds

3 months time (T = 1/4)

Loan outstanding = $100 (1+0.04/4) = $101 Deliver stocks and receipts from F.C. = $102 Riskless profit = $1

K. Cuthbertson and D. Nitzsche

Figure 2.7 : Backwardation and Contango

Forward price in contango : F > S

0
T

Stock price, St
At T, ST = FT

Forward price in backwardation : F < S

For simplicity we assume that the spot price remains constant. In practise, S and hence F will fluctuate as you approach T but with Ft > St if the market is in contang and Ft < St if the market is in backwardation.
K. Cuthbertson and D. Nitzsche

Figure 2.8 : Hedging using futures

Long Underlying
+1 + -1 0 Short Futures = Hedge

K. Cuthbertson and D. Nitzsche

Figure 2.9 : Rolling over a futures contract

Short Sept. Future
Close out Sept. Future Buy March Future Close out March Future Buy Sept. Future Close out Sept. Future

April

June

Oct.

Dec.

April June

Sept.

March

August

February

August

K. Cuthbertson and D. Nitzsche

Figure 2.10 : Value of forward contract

New 3-month forward Ft = $101.25

Initial 6-month forward Value of initial 6-month F0 = K = $90 forward Vt = (Ft - F0) e-r(T-t) Both forward contracts expire

January

March
K. Cuthbertson and D. Nitzsche

June