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
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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?
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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

Exercise Price K 
Domestic int. rate 
Foreign int. rare 
Spot rate volatility 
Time to maturity 
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Call 
Put 
Call 
Put 
Call 
Put 
Call 
Put 
Call 
Put 
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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Lecture NotesFinance 319
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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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Lecture NotesFinance 319
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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?


03.26.2001
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
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