Finance 319 Lecture 03.26.01

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					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

   03.26.2001    Lecture NotesFinance 319   1
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       2
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    3
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   4
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   5
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              6
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   7
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   8
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    9
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   10
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         11
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     12
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         13
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   14
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



  03.26.2001                   Lecture NotesFinance 319   15