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Lecture 8: Derivatives II: Currency and interest rate options Galina A Schwartz Department of Finance University of Michigan Business School

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Plan of today’s lecture n Chapter 12, Levich n Why options? n Major players [& terminology] n Option pricing: is it exact science? n Black-Scholes option pricing model n Its features & deficiencies n Future of options n Summary

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Why do we observe options? n Future contract = symmetric payoff profile n Options = nonsymmetrical payoff n Options are redundant securities n Options: -- currency -- interest rate n Players: PHLX, CME, SIMEX, etc. n Terminology: call, put, American, European

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Black-Scholes option pricing model n Continuous time lognormal approach n Underlying constants n [From Lecture 7] Current trends: [A very rough view] Volatility up, down and the reasons? Term structure of interest rates Currency premium? How to reduce volatility? -- Improve efficiency -- Impose regulation

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Summary n Option contracts: price uncertainty before maturity n Option market efficiency Is B-S model correct? Are B-S assumptions false?

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What is next [Lecture 10] n Monday, November 27, 2000: Derivatives III, Chapter 13, Levich n Have a Happy Thanksgiving!!!

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