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Finance 319 Lecture 03.26.01

Finance 319 Lecture 03.26.01. Course Website http://www.citi.umich/u/galka/319 Galina Albert Schwartz Department of Finance University of Michigan Business School. Lecture Summary. Levich, Chapter 12: continued Option Prices Efficiency and LTCM crisis: Insider and Outsider Opinions:

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Finance 319 Lecture 03.26.01

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  1. Finance 319 Lecture 03.26.01 Course Website http://www.citi.umich/u/galka/319 Galina Albert Schwartz Department of Finance University of Michigan Business School Lecture NotesFinance 319

  2. Lecture Summary • Levich, Chapter 12: continued • Option Prices Efficiency and LTCM crisis: • Insider and Outsider Opinions: • Are they the same or differ? • Which is more informative? • Could the Knowledge of History Help? • Euro: • What do we know (a short summary) • Why is it still low? • Is there any way to predict the EURO’s future? Lecture NotesFinance 319

  3. Today’s Citation: Your Wake Up Call! “It is often said that men are ruled by their imaginations; but it would be truer to say they are governed by the weakness of their imaginations,” Walter Bagehot (1826–77), English economist, critic. The English Constitution, ch. 2 (1867). Historical Curiosity: See URL: Lombard Street. A Description of the Money Marketby Walter Bagehot Quiz: What is Bagehot rule? (Levich, p. 27) Lecture NotesFinance 319

  4. Currency and Interest Rate Options: • Strike price (or exercise price) [K] – the price given by the contract • Call option - right to buy [C] • Put option – tight to sell [P] • Price paid for the option - option premium • Let S be an underlying asset price at maturity date [expiration date] Lecture NotesFinance 319

  5. Currency and Interest Rate Options: • Characteristic feature is: Asymmetric payoff profile: limited gain (loss) and unlimited loss (gain) • Levich, pp. 432 –435: At maturity: C = max[0, S - K] P = max[0, K - S] Option value is never negative. Option’s seller faces unlimited liability [since the asset could appreciate without limit] Lecture NotesFinance 319

  6. Currency and Interest Rate Options: • Levich, pp. 447, table 12.7 – a summary of marginal effects of parameter changes on Option prices • Spot Price S  Call  Put  • Exercise Price K  Call  Put  • Domestic int. rate  Call  Put  • Foreign int. rare  Call  Put  • Spot rate volatility  Call  Put  • Time to maturity  ambiguous effects Lecture NotesFinance 319

  7. Currency and Interest Rate Options: How to Price? • Option Prices depend on (Levich, p. 465) • Current asset price • Strike price • Interest rate(s) • Time to maturity • Volatility (assumed constant by Black-Scholes) • Estimating Volatility: Levich, pp. 462 - 463 • historical approach • Implied approach Lecture NotesFinance 319

  8. LTCM: was it all wrong? • See Kho, Lee & Stulz, “US Banks, Crises and Bailouts: from Mexico to LTCM • The Banks lost it, not the taxpayers? • See Miron Scholes, “Crisis and risk management”: • It was a volatility increase, not our fault Lecture NotesFinance 319

  9. Currency and Interest Rate Options: Is the Pricing Efficient? • Real Prices are higher than predicted by the B-S model. Why? • Model is wrong • Model’s assumptions do not hold exactly • Volatilities are not constant • Distributions are not normal (tails are sicker than normal) Lecture NotesFinance 319

  10. Policy Matters - Public Policymakers • As with any derivatives market, a generic question is whether the existence of the option market leads to negative spillover effects, such as an increase in the volatility of the underlying asset. • A related public policy concern is the risk to which option traders are exposed and how the capital requirements for those risks should be measured. Lecture NotesFinance 319

  11. Euro: PAST, current & future • Levich, Ch. 2, pp. 70 -72 • European Monetary Union • Past Verdict: • Too many conflicts of political / cultural interests • Too diverse economic interests, performance, traditions • Too little incentives for cross-subsidization Thus, more CONS than PROS: EMU will not be born, or it will dye fast Lecture NotesFinance 319

  12. Euro: past, CURRENT & future • European Monetary Union • Current Trends • Euro is too low (relative to fundamental level) • How to explain this? • Past Verdict is correct? • Market Participants are biased? • Are they ALL wrong? Lecture NotesFinance 319

  13. Euro: past, current & FUTURE • European Monetary Union • Expectations for Future • Too early to judge, but • Capital markets maturity improved dramatically • Non-participating countries are still reluctant to join. • It’s reflects both: history & common sense (but not always, example Danish referendum and the Central Bank Policy) • Is Current Trend self-contradictory? • To some degree • Explanations of current trend: • Market makers interests participants Lecture NotesFinance 319

  14. Summary of Today’s Lecture • Currency and interest rate options have asymmetric payoff profiles • Efficiency: Option Markets are approximately efficient • LTCM & Options Pricing efficiency • Euro: past, current & future Lecture NotesFinance 319

  15. Next Time • Swaps: another asymmetric instrument • U.S. Foreign Exchange Interventions • Central Bank(s) Intervention(s) • Cases for intervention (example of EURO) • Implementation strategy • Success or failure? • Sterilization & Sterilized Intervention • Costs & benefits of intervention Lecture NotesFinance 319

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