# 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

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?
    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
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
 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,
» 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)
   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

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