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)

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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]

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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]

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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

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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

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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

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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)

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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.

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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

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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?

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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

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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

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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