03.26.2001lecture notesfinance 3191 finance 319 lecture 03.26.01 course website galina albert...
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03.26.2001 Lecture NotesFinance 319 1
Finance 319 Lecture 03.26.01
Course Website
http://www.citi.umich/u/galka/319
Galina Albert SchwartzDepartment of FinanceUniversity of Michigan Business School
03.26.2001 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?
03.26.2001 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 Market
by Walter Bagehot
Quiz: What is Bagehot rule? (Levich, p. 27)
03.26.2001 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]
03.26.2001 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]
03.26.2001 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
03.26.2001 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
03.26.2001 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
03.26.2001 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)
03.26.2001 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.
03.26.2001 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
03.26.2001 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?
03.26.2001 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
03.26.2001 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
03.26.2001 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