Options: Expensive Compared to What?
11 May 2009
Sean Russo
IN MY opinion options are the singularly most useful price risk management tool available to corporate hedgers. It is also my experience that they are significantly misunderstood which leads to them either being under-utilised (if used at all) or incorrectly utilised by many corporations.
Options can provide very different benefits to different users. They essentially have a split personality which leads to some of the confusion regarding their proper role in a corporate hedging policy.
Tool of the Highly Geared Speculator
To many people options are seen as the tool that allows speculators to harness considerable gearing for a modest and limited cost. This is true – some people do buy options to make geared bets on the direction of the market. Of the factors that combine to create the price of options, time is a major component and as the value of bought options decay with each passing day, the timing of these bets is crucial to the success of the trades. Even when option traders get the direction right, they need the market to move through the options strike price by at least the amount of the premium paid plus the funding costs of the premium to break even. This is the reason that it is a seemingly well known statistic in the market that most options traded expire worthless - a figure as high as 80% is often bandied around.
Tool of the Conservative Corporate Hedger
The purchase of an option to underwrite a particular exposure to a given market is significantly different for a corporation with risk. If the option is purchased to give price insurance in the case of an adverse move then the option will have been of most relative value if it expires worthless because the underlying exposure can be converted at a rate better than the rate “insured” by the option. The smart corporate buyer buys options and hopes they expire worthless seeing the option as a cost of minimising the harm of significant and unanticipated adverse market movements. Here the oft quoted statistic of most options expiring worthless should please the buyer.
In this role they are compared to insurance but they are much better than insurance. Firstly they are tradeable and secondly there is no claims department!
Real Cost of Options
The cost of the option at expiry is easy to measure because it is the same as the cost at the outset - the premium. The problem is they need to be paid for upfront whereas the “cost” of other hedging is only known at the end and the cost of not hedging is often never acknowledged. With hindsight relative value judgments can be made and it is easy to assess the merits or otherwise of the option when compared to the spot price at maturity, but risk exists now and decisions need to be made.
A great deal of the literature on option based hedging shows pay-off diagrams where the ‘real’ cost of an option at maturity is considered to be the difference between the final price achieved and the forward price that could have been achieved had a forward transaction been chosen over an option. For example, in the purchase of a call option, the suggestion is that an option will appear to have cost more than a forward unless the final price is better than the forward less the original outlay for the option.
This analysis is overly simplistic in as much as it assumes forwards could have been transacted for the time and volume involved. This may not be the case - in an extreme example the company may have made a decision to lock in extremely favourable rates for a period and volume beyond the limit of its own hedging policy governing fixed commitments or the facilities provided by its hedge providers. More importantly it completely ignores the journey risk the two parties had between the time the transaction was entered into and maturity.
Unlike the forward buyer the option holder preserved complete flexibility over the life of the transaction, analysis only at the maturity ignores that the holder may have seen prices significantly lower than the forward price available at outset during the period and chosen to deal at those prices. The option holder also didn’t suffer the adverse credit implications of negative mark to market and had no delivery commitment risks. In short the one off pay-off at maturity analysis ascribes no value to the enormous flexibility offered by the product over life. This is an issue that needs to be dealt with at the core of any hedging policy; each company needs to determine the value it places on that flexibility when doing its own what-if analysis when deciding whether to enter into forwards or options or indeed to hedge at all.
The next time you hear someone say they would like to use options but they are too expensive, pose a question. “Expensive compared to what?”