"Lec 20 - Dynamic Hedging" Financial Theory (ECON 251) Suppose you have a perfect model of contingent mortgage prepayments, like the one built in the previous lecture. You are willing to bet on your prepayment forecasts, but not on which way interest rates will move. Hedging lets you mitigate the extra risk, so that you only have to rely on being right about what you know. The trouble with hedging is that there are so many things that can happen over the 30 year life of a mortgage. Even if interest rates can do only two things each year, in 30 years there are over a billion interest rate scenarios. It would seem impossible to hedge against so many contingencies. The principle of dynamic hedging shows that it is enough to hedge yourself against the two things that can happen next year (which is far less onerous), provided that each following year you adjust the hedge to protect against what might occur one year after that. To illustrate the issue we reconsider the World Series problem from a previous lecture. Suppose you know the Yankees have a 60% chance of beating the Dodgers in each game and that you can bet any amount at 60:40 odds on individual games with other bookies. A naive fan is willing to bet on the Dodgers winning the whole Series at even odds. You have a 71% chance of winning a bet against the fan, but bad luck can cause you to lose anyway. What bets on individual games should you make with the bookies to lock in your expected profit from betting against the fan on the whole Series? 00:00 - Chapter 1. Fundamentals of Hedging 15:38 - Chapter 2. The Principle of Dynamic Hedging 24:26 - Chapter 3. How Does Hedging Generate Profit? 43:48 - Chapter 4. Maintaining Profits from Dynamic Hedging 54:08 - Chapter 5. Dynamic Hedging in the Bond Market 01:10:30 - Chapter 6. Conclusion Complete course materials are available at the Open Yale Courses website: http://open.yale.edu/courses This course was recorded in Fall 2009.
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Tags: Lec 20 - Dynamic Hedging
Uploaded by: yalefinancialth ( Send Message ) on 12-09-2012.
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Lec 2- Utilities, Endowments, and Equilibrium
Lec 4- Efficiency, Assets, and Time
Lec 5- Present Value Prices and the Real Rate of Interest
Lec 6 - Irving Fisher's Impatience Theory of Interest
Lec 7 - Shakespeare's Merchant of Venice and Collateral, Present Value and the Vocabulary of Finance
Lec 8 - How a Long-Lived Institution Figures an Annual Budget. Yield
Lec 10 - Dynamic Present Value
Lec 12 - Overlapping Generations Models of the Economy
Lec 13 - Demography and Asset Pricing: Will the Stock Market Decline when the Baby Boomers Retire?
Lec 14 - Quantifying Uncertainty and Risk
Lec 15 - Uncertainty and the Rational Expectations Hypothesis
Lec 16 - Backward Induction and Optimal Stopping Times
Lec 17 - Callable Bonds and the Mortgage Prepayment Option
Lec 18 - Modeling Mortgage Prepayments and Valuing Mortgages
Lec 19 - History of the Mortgage Market: A Personal Narrative
Lec 21 - Dynamic Hedging and Average Life
Lec 22 - Risk Aversion and the Capital Asset Pricing Theorem
Lec 23 - The Mutual Fund Theorem and Covariance Pricing Theorems
Lec 24 - Risk, Return, and Social Security
Lec 25 - The Leverage Cycle and the Subprime Mortgage Crisis