1. 03.26.2001Lecture NotesFinance 3191 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

2. 03.26.2001Lecture NotesFinance 3192 Lecture Summary u Levich, Chapter 12: continued u Option Prices Efficiency and LTCM crisis: u Insider and Outsider Opinions: –Are they the same or differ? –Which is more informative? u Could the Knowledge of History Help? u Euro: –What do we know (a short summary) –Why is it still low? –Is there any way to predict the EURO’s future?

3. 03.26.2001Lecture NotesFinance 3193 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 Lombard Street. A Description of the Money Market by Walter Bagehot Quiz: What is Bagehot rule? (Levich, p. 27)

4. 03.26.2001Lecture NotesFinance 3194 Currency and Interest Rate Options: u Strike price (or exercise price) [K] – the price given by the contract u Call option - right to buy [C] u Put option – tight to sell [P] u Price paid for the option - option premium u Let S be an underlying asset price at maturity date [expiration date]

5. 03.26.2001Lecture NotesFinance 3195 Currency and Interest Rate Options: u Characteristic feature is: Asymmetric payoff profile: limited gain (loss) and unlimited loss (gain) u 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]

6. 03.26.2001Lecture NotesFinance 3196 Currency and Interest Rate Options: u 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

7. 03.26.2001Lecture NotesFinance 3197 Currency and Interest Rate Options: How to Price? u Option Prices depend on (Levich, p. 465) –Current asset price –Strike price –Interest rate(s) –Time to maturity –Volatility (assumed constant by Black-Scholes) u Estimating Volatility: Levich, pp. 462 - 463 –historical approach –Implied approach

8. 03.26.2001Lecture NotesFinance 3198 LTCM: was it all wrong? u See Kho, Lee & Stulz, “US Banks, Crises and Bailouts: from Mexico to LTCM –The Banks lost it, not the taxpayers? u See Miron Scholes, “Crisis and risk management”: –It was a volatility increase, not our fault

9. 03.26.2001Lecture NotesFinance 3199 Currency and Interest Rate Options: Is the Pricing Efficient? u 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)

10. 03.26.2001Lecture NotesFinance 31910 Policy Matters - Public Policymakers u 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. u 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.

11. 03.26.2001Lecture NotesFinance 31911 Euro: PAST, current & future u Levich, Ch. 2, pp. 70 -72 u European Monetary Union 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

12. 03.26.2001Lecture NotesFinance 31912 Euro: past, CURRENT & future u European Monetary Union European Monetary Union –Current Trends »Euro is too low (relative to fundamental level) »How to explain this? u Past Verdict is correct? u Market Participants are biased? u Are they ALL wrong?

13. 03.26.2001Lecture NotesFinance 31913 Euro: past, current & FUTURE u European Monetary Union European Monetary Union –Expectations for Future »Too early to judge, but u Capital markets maturity improved dramatically u Non-participating countries are still reluctant to join. u It’s reflects both: history & common sense (but not always, example Danish referendum and the Central Bank Policy) »Is Current Trend self-contradictory? u To some degree u Explanations of current trend: –Market makers interests participants

14. 03.26.2001Lecture NotesFinance 31914 Summary of Today’s Lecture u Currency and interest rate options have asymmetric payoff profiles u Efficiency: Option Markets are approximately efficient u LTCM & Options Pricing efficiency u Euro: past, current & future

15. 03.26.2001Lecture NotesFinance 31915 Next Time u Swaps: another asymmetric instrument u U.S. Foreign Exchange Interventions U.S. Foreign Exchange Interventions u Central Bank(s) Intervention(s) –Cases for intervention (example of EURO) »Implementation strategy »Success or failure? –Sterilization & Sterilized Intervention –Costs & benefits of intervention