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24Lecture24

# 24Lecture24 - Economics 136 Financial Economics Final Exam...

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Economics 136: Financial Economics Final Exam Review November 28, 2012 Final Exam Review: R. J. Hawkins Econ 136: Financial Economics 1/ 2

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The Contingent-Claim Pricing Paradigm We began with the Unit Trust . . . 0 50 100 150 200 250 300 0 50 100 150 200 250 300 VALUE OF UNIT TRUST (USD) VALUE OF SPY INVESTMENT (USD) Asset Liability (Debt), t = 1 Liability (Debt), t = 0 Equity, t = 1 Equity, t = 0 Final Exam Review: R. J. Hawkins Econ 136: Financial Economics 2/ 2
Financial Economics Introduction 0 50 100 150 200 250 300 0 50 100 150 200 250 300 0.00 0.01 0.02 0.03 VALUE OF UNIT TRUST (USD) PROBABILITY VALUE OF SPY INVESTMENT (USD) Value Liability (Debt) Equity Probability 0 50 100 150 200 250 300 0 50 100 150 200 250 300 VALUE OF UNIT TRUST (USD) VALUE OF SPY INVESTMENT (USD) Asset Liability (Debt) Equity The Unit Trust Asset, debt (liability) and equity. Asset = Liability + Equity The Law of One Price. Probability and future uncertainty. Probability, Returns & Risk: R. J. Hawkins Econ 136: Financial Economics 3/ 20

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Returns Consider the following data for Microsoft: Price (08/25/08) Dividend Price (08/25/09) USD 27.66 USD 0.52 USD 24.64 The return is r ( t ) = x ( t + τ ) x ( t ) + income costs x ( t ) = 24 . 64 27 . 66 + 0 . 52 27 . 66 = 3 . 02 + 0 . 52 27 . 66 = 0 . 09 = 9% Probability, Returns & Risk: R. J. Hawkins Econ 136: Financial Economics 12/ 20
SPY Cumulative Return Distribution More Data 10 -5 10 -4 10 -3 10 -2 10 -1 10 0 0 5 10 15 CDF(-x), 1-CDF(x) RETURN (%) Gaussian Probability, Returns & Risk: R. J. Hawkins Econ 136: Financial Economics 18/ 20

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Covered Interest Parity & Keynes “If by lending dollars in New York for one month the lender could earn interest at the rate of 5 1 / 2 % per annum, whereas by lending sterling in London for one month he could only earn interest at the rate of 4 %, then the preference observed above for holding funds in New York rather than in London is wholly explained. That is to say, forward quotations for the purchase of the currency of the dearer money market tend to be cheaper than spot quotations by a percentage per month equal to the excess of the interest which can be earned in a month in the dearer market over what can be earned in the cheaper.” – J. M. Keynes, A Tract on Monetary Reform (1923) R. J. Hawkins: Covered Interest Parity Econ 136: Financial Economics 2/ 22
Covered Interest Parity: Examples By arbitrage: S f / d (1 + r f ) = (1 + r d ) F f / d Two basic questions: 1 Solve for one variable given the other three. 2 Identify arbitrage trade opportunities. R. J. Hawkins: Covered Interest Parity Econ 136: Financial Economics 13/ 22

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Arbitrage Example 1 Recall our basic equality: S f / d (1 + r f ) = (1 + r d ) F f / d . What to do if (1 + r d ) > S f / d (1 + r f ) F f / d = S f / d (1 + r f ) F d / f 1 Construct position (portfolio) today: 1 Borrow from foreign bank. (short a deposit) 2 Covert loan to domestic currency at the spot rate. 3 Lend to domestic bank. (long a deposit) 4 Enter into domestic-to-foreign forward fx position. 2 Close out position (portfolio) in the future: 1 Take proceeds from domestic deposit.
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24Lecture24 - Economics 136 Financial Economics Final Exam...

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