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Economics 434 Theory of Financial Markets

Economics 434 Theory of Financial Markets. Professor Edwin T Burton Economics Department The University of Virginia. Three Main Types of Derivatives. Options Futures (Forwards) Swaps. Swaps. Originated in the debt market Borrowers “swapped” their obligations to their debtors

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Economics 434 Theory of Financial Markets

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  1. Economics 434Theory of Financial Markets Professor Edwin T Burton Economics Department The University of Virginia

  2. Three Main Types of Derivatives • Options • Futures (Forwards) • Swaps

  3. Swaps • Originated in the debt market • Borrowers “swapped” their obligations to their debtors • Fixed to floating; floating to fixed • Short to long maturities; long to short • Migrated to equities • Sometimes equities swapped for debt

  4. A “Plain Vanilla” Swap • Imagine that UVA has sold long term debt at a fixed rate of 8 % • Imagine that BIG Industries has sold long term debt with a variable rate that is reset every year at the “target funds rate” on Jan 1st plus 100 basis points • Last January this would be 4 ½ percent plus 100 basis pts (1 %) for a total of 5 ½%

  5. “Plain Vanilla Swap”The Details Before the swap, are the payment obligations in 2012

  6. What about 2013Suppose Target Funds Rate 1/1/13 is 7 ½%

  7. In future years • On Jan 1, observe the new target funds rate, add 1 % and that is BIG’s obligation that becomes UVAs obligation • BIG’s obligation might go up or down depending upon where the target funds rate goes

  8. Final Exam, Wed Dec 12th 2 PM • Wilson Auditorium • Write on exam; bring no materials to final; no calculators; nothing. • Three hours; should finish in two hours or less

  9. Final is cumulative; everything is fair game; nothing is rule out • Subjects: • Fixed Income • Present Value • Mortgage Securities • Treasury Securities • MPT • Markowitz, Tobin, CAPM • Leverage • M-M theorems; balance sheet issues • Derivatives: options, futures, swaps

  10. The End

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