Friday, December 31, 2010

Options as a basic life skill

There are frequent calls to include personal finance topics as an essential life skill that should be taught in high school.  I'd suggest that options topics are important life understandings as well.  These include:

The legal concepts and of obligations and rights.  Essential to understanding any contract.  Options are the simplest form of rights and obligations triggered by a (hopefully) simple measurable event.
The equivalency of short puts and calls to buy and sell offers, and the advantage of doing so if the offer has relative permanence.
The equivalency of owning an asset with a long call and short put position.

The ability to understand this last point of option equivalencies to assets and financial instruments, is key to understanding alternative financial instruments including natural finance.

A corporation is fundamentally a call option (with unlimited duration, strike price of 0) given by bond holders and other debt holders to shareholders.  Shareholders are entitled only to surpluses above and beyond the full repayment of bond holders.  Through bankruptcy legislation and process, bondholders effectively hold a put option (unlimited duration strike price of somewhat indetermined less than zero) given by shareholders for taking over the company in event of insolvency.

Options can create value out of thin air.  Someone who owns a stock currently valued at $50 can decide to sell it if it reaches $60, and not sell it if it drops to $10.  By writing an option with strike price of $60, the stock owner has the exact same risk profile as his current attitude, but is paid to keep it.  The buyer of the option gains all the benefits of the stock rising above 60, with no risks of it dropping far below $60.  If the option writer is indeed paid to do something he would have done anyway, the value creation is entirely captured by him, though the buyer voluntarily pays what is a fair price to him.

Insurance also has strong options analogies.  A policy holder who has replacement value coverage for an asset holds a put option on that asset at strike price of the replacement value less deductible.  It isn't quite a pure option in that the rights to exercise are convoluted, and can be objected to by the insurer.  In fact, when replacement value is well above market value of the asset, trying to exercise the policy holder's put is likely to arouse suspicions of insurance fraud.  Alternative insurance structures could create value by reducing the put's strike price.  It would lower premiums, and increase trust by both insurer and insuree by lowering suspicion of fraud if there is a claim.

Progressive taxation can also be seen as a series of call options you have been made to grant to the government/society.  Progressive taxation is widely accepted as inherently fair.  The argument for it is that those who extract the most value from society should repay society more than those less fortunate or able.  Resulting income equality staves off social unrest.  The interesting aspect of these options obligations is the relative complacency those involved have towards ever increasing taxation obligations on marginal income.  2 factors explain this complacency.  First, psychology makes you more docile about payment when it is based on success and you can afford it.  Second, we universally prefer trading off fixed risk for less potential ultimate reward.  A flat $10K per US adult in taxes would not pass democratic approval regardless of republican PR capabilities.  Offering an increased share in our success is an attractive trade to lower the chance of destitute bankruptcy.

This later concept, of universal preference for trading off risk and certainty for return,  forms one of the basis for using capped queued soft loans in natural finance.  When buying a security, issuing the seller a call option at double the purchase price is unlikely to meaningfully affect the transaction's price or attractiveness.  The cap also serves to self-mitigate greed and desperation at time of financing, and enhance the predictability of investor returns.

The importance of options as a financial engineering instrument is its design to compartmentalize and subdivide risk.  The insurance analogy transfers risk from those that can't afford it (policy holders) to those who can diversify the risk among several policies.  All value creation through financial engineering is through either risk reduction or trust enhancement.  Natural Finance focuses on both these forces to design enterprise structure and financing.  Understanding natural finance, depends on understanding options.  Understanding options also enables understanding financial engineering and solutions in general.  A population that is educated in these matters is better able to participate in financial solutions, and hopefully understand and defend against predatory financial propositions.  Whether finance concepts best belong at a high school level, or treated as a liberal arts undergraduate compulsory, strengthen a nation's intellectual and economic capacity.

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