U.S. patent application number 10/757933 was filed with the patent office on 2005-07-21 for model options.
Invention is credited to Thomas, Bruce Bradford.
Application Number | 20050160027 10/757933 |
Document ID | / |
Family ID | 33435638 |
Filed Date | 2005-07-21 |
United States Patent
Application |
20050160027 |
Kind Code |
A1 |
Thomas, Bruce Bradford |
July 21, 2005 |
Model options
Abstract
A method for devising an option contract so that it is valued
based on a pre-defined formula.
Inventors: |
Thomas, Bruce Bradford;
(Trumbull, CT) |
Correspondence
Address: |
Bruce Bradford Thomas
145 Lake Avenue
Trumbull
CT
06611
US
|
Family ID: |
33435638 |
Appl. No.: |
10/757933 |
Filed: |
January 15, 2004 |
Current U.S.
Class: |
705/37 |
Current CPC
Class: |
G06Q 40/04 20130101;
G06Q 40/06 20130101; G06Q 40/00 20130101; G06Q 30/0283
20130101 |
Class at
Publication: |
705/037 |
International
Class: |
G06F 017/60 |
Claims
1-15. (canceled)
16. A method for devising an option contract so that said
contract's value is determined by a methodology that uses an option
pricing model, whereby financial leverage can be achieved in a way
that is simpler and more cost-effective than by using traditional
options.
17. The contract of claim 16 that derives its value from any type
of real or personal property.
18. The contract of claim 16 that is traded between two parties
using the physical location or electronic trading mechanism of a
third party.
19. The contract of claim 16 that is used to compensate managers
and other employees of a business.
20. The contract of claim 16 that is included as one or more
provisions of some other type of contract.
21. The contract of claim 16 that is settled by a payment of
cash.
22. A method for devising an option contract that is used to
compensate a company's managers and employees so that said
contract's value is determined by a methodology that uses an option
pricing model, whereby financial leverage can be achieved in a way
that is simpler and more cost-effective than by using traditional
incentive stock options.
23. The contract of claim 22 that is settled by a payment of
cash.
24. The contract of claim 22 that is structured as one or more
provisions in any type of contract.
25. The contract of claim 22 that derives its value from any type
of real or personal property.
26. A method for devising an option contract that is traded on an
exchange so that said contract's value is determined by a
methodology that uses an option pricing model, whereby financial
leverage can be achieved in a way that is simpler and more
cost-effective than by using traditional exchange-traded
options.
27. The contract of claim 26 that derives its value from any type
of real or personal property.
28. The contract of claim 26 that is settled by a payment of cash.
Description
CROSS-REFERENCE TO RELATED APPLICATIONS
[0001] Not Applicable
FEDERALLY SPONSORED RESEARCH Not Applicable
SEQUENCE LISTING OR PROGRAM Not Applicable
BACKGROUND OF THE INVENTION
[0002] 1. Field of Invention
[0003] This invention relates to options where the underlying may
be a financial asset, a commodity, or some other type of real or
personal property.
[0004] 2. Background of the Invention
[0005] Options
[0006] Option contracts give the holder a right to buy or sell
property at a specified price, called the strike or exercise price,
within a given period of time for an agreed upon sum. The payment
that is exchanged for this right is called the option premium. If
the option holder does not exercise his right within the given
period of time, the option expires worthless.
[0007] Having the right but not the obligation to buy or sell
property at some prespecified price is valuable. This is why option
buyers are willing to pay option sellers a premium for this right.
Since options derive their value from the price of the underlying
assets they are considered derivatives.
[0008] The Value of an Option
[0009] An option's value can be thought of as having two primary
components. The intrinsic value is the value that an investor would
get if she immediately exercised the option. This is the difference
between the current price and the exercise price and is also
described as "moneyness." If the option has a positive intrinsic
value, meaning that the exercise price is less than the current
price of the asset, it is said to be "in-the-money." Thus, deep
in-the-money options refer to options that have strike prices
substantially below the underlying asset price and deep
out-of-the-money options refer to options that have strike prices
substantially above the underlying asset price.
[0010] The second component of an option's value results from how
likely and in what direction the intrinsic value of the option is
expected to change over the life of option. This is a function of
the underlying asset's propensity to change in value and the
remaining life of an option.
[0011] Although many options expire without value, most options
that are in-the-money are bought or sold, rather than exercised.
This is because exercising an option early forfeits the remaining
time value of the option. Also, exercising an option and converting
it into the underlying property destroys the financial leverage
that options enable.
[0012] Financial Leverage
[0013] Options are beneficial because they allow the holder to gain
financial leverage by buying just the portion of the underlying
property that the holder believes is desirable. For example, a
speculator who believes that a particular stock will rise to $60
within the next three months from its current price of $50 has a
choice of buying the underlying stock or options on the stock.
[0014] Assuming that the speculator has $5,000 to invest and a
three-month option to buy one share at a strike price of $50 cost
$3.58, the speculator can buy either 100 shares of the stock or
purchase 1,396 options to buy the stock. The options are
significantly cheaper than the stock because they are only valuable
if the stock price increases above $50 per share during the next
three months.
[0015] If the speculator is correct and the stock price increases
to $60, she will make $1,000 if she purchases the stock. She will
make $8,962 if she purchases the options ($60-$50=$10 per share
increase times $1,396 options=$13,960 less the option premium of
$4,998). Thus, it can be seen that it is much more efficient for
the speculator to buy options than to buy the underlying stock.
[0016] Option Usage
[0017] Exchanges facilitate the trading of options on stock,
commodities, currencies, and debt instruments. An exchange can be a
physical location or an electronic mechanism where trading takes
place. Although options can be traded directly between two
individuals or companies, this rarely happens in practice. This is
because exchanges assist in the price discovery process and provide
a valuable role in minimizing credit risk.
[0018] Options are used in many different ways. Speculators use
options to bet on the underlying property increasing or decreasing
in value over some specified period of time. Assuming a speculator
believes that the underlying property's price will decrease, she
may purchase a put option, giving her the right to sell that
property to the option seller at a pre-specified price. Conversely,
if she believes that the price will increase, she may desire to
purchase a call option that will give her the right to buy the
property from the option seller at a pre-specified price.
[0019] Many investors use options to hedge or offset the risk of
some component of their portfolio. For example, a stockholder who
is concerned that stock prices may fall dramatically might buy put
options and sell call options to limit the potential loss of value.
Similarly, manufacturers may desire to hedge price increases or
decreases associated with their raw material inventories.
[0020] Stock Option Types
[0021] There are three basic types of stock options. American style
stock options enable the holder to exercise the option at any point
prior to the expiration date. European style stock options only
enable the holder to exercise the option on the expiration date.
Burmudian stock options may be exercised at any one of various
pre-set points during the life of the option.
[0022] Incentive Stock Options
[0023] Another type of option in widespread use is the incentive
stock option. Incentive stock options are granted to corporate
managers and employees as a means of motivating them to achieve
certain financial and operational objectives. These options are
usually granted at a strike price that is at or above the price of
the underlying stock on the grant date and these options often vest
over a period of future employment such as three or four years. In
addition, incentive stock options usually have much longer terms
than exchange traded stock options.
[0024] There has been significant controversy in recent years over
the use of incentive stock options. While part of the debate is
focused on the suspicion that corporate executives are too highly
compensated, this concern is fuelled by disputes over option
valuation and how best to show this compensation in the books and
records. From an accounting perspective the issues are about how
best to show the dilutive effects of such options and whether to
show them as an expense, which then gets into questions of how to
measure the expense and how best to show the expense in the
financial statements. The Financial Accounting Standards Board
issued Statements of Financial Standards No. 123 and No. 148 to
resolve the accounting treatment of incentive stock options.
[0025] Nevertheless, the fair value approach that the new standards
require is still controversial. Since there is no publicly traded
market for these options, it is impossible to use the market as a
means to determine how these options should be valued.
Additionally, many people disagree about whether the current option
pricing models produce meaningful valuations of long-duration
option contracts.
[0026] As a result, some companies have discontinued the use of
incentive stock options and are now granting stock and restricted
stock to their employees instead. While it is certainly easier to
measure the cost of a share of restricted stock than a stock
option, this change gives-up the benefit of financial leverage that
characterizes options and motivates employees to achieve specific
objectives. Thus, instead of giving an employee options so that she
only benefits if the stock price increases above a certain level,
the company may now give her the entire share value so as to avoid
complex valuation issues.
[0027] Option Pricing Models
[0028] A number of mathematical models have been developed to
determine the theoretical value of an option. The first of these
models to achieve widespread acceptance was the Black and Scholes
Option Pricing Model which was introduced in 1973. This model is
predicated upon the following assumptions: the stock pays no
dividends; European exercise terms are used; markets are efficient;
no commissions are charged; interest rates are known and constant;
and returns are lognormally distributed. Since each of these
assumptions can be debated, this model has been modified overtime
and other models have been developed to correct certain perceived
weaknesses of the Black and Scholes Model.
[0029] For example, the Binomial Model breaks down the time to the
expiration of an option into discrete intervals. At each interval,
the stock is assumed to increase or decrease by a certain amount
based on its volatility and time to expiration. In effect, this
produces a tree of potential stock prices over the life of the
option with each branch representing a possible path that the stock
price could take during the remaining life of the option.
Probabilities are then applied to each path to produce the expected
value of the option.
[0030] Although a number of option price models have been developed
since the Black and Scholes Model, this Model is still widely used
due to the fact that it can be calculated faster than some of the
newer models that require iterative calculations. Calculation speed
is essential in a market where option prices can change very
quickly.
[0031] Despite the different techniques that they employ, the
models require essentially the same inputs to create an option's
theoretical value. These inputs are: the current stock price, the
exercise price, the time to expiration, the risk-free interest
rate, the dividend rate, and the volatility of the underlying
stock.
[0032] Uncertain Option Values
[0033] Despite new and improved option pricing models, there is
still significant uncertainty about what the value of an option is.
This uncertainty is resident before the contract is entered into
and extends until the date the contract expires, at which point the
theoretical value and the market value converge.
[0034] Actual option prices may vary significantly from the
theoretical values of the option pricing models due to a lack of
liquidity. Thin trading may impede price discovery and allow for
greater pricing imperfections. This may cause significant pricing
distortions on options that do not trade very much such as options
on smaller companies, option contracts with expiration dates
greater than one year, and deep in or out-of-the-money
contracts.
[0035] However there are significant differences between the model
values and the market values even when options are heavily traded.
Proponents of option pricing models naturally assume that these
differences are caused by different market participants using
different assumptions about the inputs to those models.
[0036] Since the current stock price, the exercise price, and the
time to expiration are fixed, these parameters are not subject to
dispute. While the risk-free interest rate and the dividend rate
may change, these values do not generally change enough over
short-periods of time to cause big changes in option values.
[0037] Thus, the parameter most in dispute is the volatility of the
underlying stock. Historical volatility can vary significantly
based on how the calculation is done and by how many days of
historic price changes are used to derive this number.
[0038] Implied Volatility
[0039] One can take the current market value of an option and the
other less contentious model inputs described above and substitute
volatilities into the model until it produces a theoretical value
that is equal to the market value of the option. This number is
called "implied volatility." In essence, implied volatility is how
market participants reconcile actual option prices with the
theoretical values derived from the models they use.
[0040] One way to describe the difference between historical
volatility and implied volatility is to say that market
participants think the historical experience of a stock's price
changes were abnormal. In effect, they think that the historical
experience was more or less volatile than what will happen over the
future life of the option.
[0041] For those participants who believe that their chosen option
pricing model adequately describes the value of an option, implied
volatility may be useful for reconciling the model with the market.
However, this number is not very meaningful for deep in or
out-of-the-money options, where extraordinary amounts of volatility
are required to change the option value by relatively small amounts
of money.
[0042] New Approach Needed
[0043] Given how useful they can be, options are not employed
nearly as much as they should be. There are several fundamental
reasons why options are not used more.
[0044] First, option calculations are relatively complicated and
difficult for the average investor to understand. The learning
curve is steep for most investors, and the details of option usage
are difficult to explain to the uninitiated. This lack of
understanding makes many investors uncomfortable with using
options.
[0045] Second, since most options are traded on exchanges, option
prices are subject to market distortions which may prevent even the
most astute observers from being able to use them effectively.
While there is significant trading of stock options at or
near-the-money for the largest companies, there may be little or no
trading of deep out-of-the-money options on those stocks. Moreover,
there is not much liquidity for options that extend beyond one year
or for options on the stocks of smaller companies either.
[0046] Third, although theoretical models of option valuation may
help provide some insight into the pricing of options, they are
also problematic. There are now many models to chose from, each
with some subtle difference, each meant to address some theoretical
problem. Despite all of the advances, there are still significant
differences between the model prices and the market prices of
options. Such differences are confusing to investors. Either the
models are wrong or the market is wrong, but how is the investor to
know which is right?
[0047] Forth, since there is not much of a market for long-duration
options such as incentive stock options, one cannot compare the
model valuations to the market valuations for such options. Thus,
one cannot even demonstrate that the models work as well in such
situations as they do on contracts with lesser expiration dates.
This is problematic given that current accounting treatment
requires companies to ascribe a fair value to incentive stock
options.
[0048] Fifth, the trading cost of using options can impair the use
of deep out-of-the-money options. This is because the expense of
trading such options gets too large in relation to the expected
value of such options.
[0049] Ultimately option usage is curtailed because people do not
understand how they work and they are suspicious that the price of
options may be incorrect, regardless of whether it is derived from
an option pricing models or the market. In effect, the degree of
moneyness, company size characteristics, and near-term expiration
dates all limit the potential size of the options market and in
turn limit its usefulness to investors.
[0050] Option pricing must be better understood by market
participants. There must be a way of valuing options with greater
certainty.
BACKGROUND OF INVENTION--OBJECTS AND ADVANTAGES
[0051] The object of the invention is a method that enables
companies and individuals to employ the financial leverage and
theoretical characteristics of options without being bound by the
limitations and imperfections of the traditional option market.
Model options objectify the uncertainty associated with the pricing
of options using an agreed value approach.
[0052] Model Options help expand the usefulness of options by
enabling participants to easily understand the components of option
valuation and to provide ready and continuous access to option
pricing, even when there is no active options market. With Model
Options, debates about marking-to-model and marking-to-market
disappear.
[0053] In the case of incentive stock options, companies and
employees can make use of the financial leverage associated with
options without having to worry about whether the option pricing
model they use is accurate. With Model Options, the model
accurately specifies the value of an option because it is the value
of that option.
[0054] With Model Options, buyers and sellers no longer need to be
wary of long-duration, or deep in-the-money or deep
out-of-the-money options. They can confidently employ options to
help them gain financial leverage because they can be confidant
that thin markets and poor liquidity will not distort prices.
[0055] Since price discovery is not necessary for Model Options,
buyers and sellers can trade without the need for a traditional
market such as an exchange. By alleviating the need for options to
be traded on an exchange, option usage can be significantly
expanded and trading costs can be reduced. This is especially true
for deep out-of-the-money options where the expected value of such
options may be less than the transaction fees. The current
market-based approach to option pricing discourages trading of such
options because the fees are static and participants end up paying
trading cost that are too large in relation to what the underlying
options are worth to be economical.
[0056] Model Options enable options to be traded on small company
stocks. Currently, options exchanges are not interested in such
trading because it does not represent a significant amount of
transaction volume, and the cost of such activity is not worth
their trouble. Conversely, market participants generally steer away
from such trading due to fears of pricing distortions and the
potential for manipulation.
[0057] Model Options can be priced continuously, enabling interim
settlements of value. This is a helpful means of reducing
counter-party credit risk. For example, buyers and sellers could
agree that they will make interim payments to one another for
increases and decreases in the value of an option once that option
has a positive intrinsic value.
[0058] Unlike traditional Options, Model Options can be structured
so that they never permit the holder to exercise the option.
Instead of forcing the holder to pay the exercise price to receive
the underlying asset, the parties can structure a Model Option so
that the holder can receive its value at expiration. This reduces
transaction costs and may be especially useful when the option
holder has no interest in converting the option into the
underlying.
[0059] Another useful feature of Model Options is that each of the
component parts of option valuation is specifically identified.
This characteristic makes it possible for option participants to
trade each of the underlying components of an option separately.
For example, option buyers and sellers could agree to trade just
the volatility component of an option.
[0060] Model Options may be applied to any type of option
regardless of whether the underlying is a financial asset, a
commodity, or an item or collection of real or personal
property.
[0061] Further objects and advantages are to increase the use of
options by making their values more understandable and more
reliable and by making them more cost-effective to trade. Other
objects and advantages will become apparent from a consideration of
the ensuing description and drawings.
SUMMARY
[0062] This method permits a buyer and seller to exchange the
financial characteristics of an option by agreeing on the
characteristics of that option and a methodology that will be used
for valuing that option. In essence, a Model Option is an option
contract that specifies a formula that will be used to determine
its value.
[0063] Instead of relying on the market to generate the appropriate
value for an option, Model Options specify how an option will be
valued by describing a calculation methodology and how each of the
inputs to that calculation will be derived. In addition to
describing an underlying asset, a strike price, an expiration date,
and the type of exercise that is allowed (American, European,
etc.), Model Options specify a particular option pricing model
(such as the Black and Scholes, the binomial, etc.) and how each of
its inputs will be calculated (i.e., the risk-free rate of
interest, the historical volatility of the underlying assets price,
the dividend rate, etc.).
[0064] This "agreed value" approach to option valuation may be used
to determine the initial price of the option, the value of an
option at any point during the term of the contract, and the value
at the expiration of the contract. Thus, Model Options can be used
in conjunction with the present market-based model of option
pricing in many different ways.
DRAWINGS--FIGURES
[0065] FIG. 1 shows how a buyer and seller might use this method to
enter into a Model Option contract that will enable them to
determine the value of the option at any point from contract
inception to expiration.
DETAILED DESCRIPTION--FIGS 1--PREFERRED EMBODIMENT
[0066] An overview of how a buyer and seller might use this method
to enter into a Model Option contract is shown in FIG. 1. To enter
into a Model Option contract, a buyer and seller must agree on the
basic terms of that option 1 and must agree on a methodology that
they will use to value the option 3. If they can agree on these
terms then the buyer will pay the seller an option premium as
specified by their contract 4. If they are unable to agree on the
basic option terms and the valuation methodology, they will not
enter into a Model Option contract 2.
[0067] Operation of the Invention
[0068] The basic option terms that buyers and sellers must agree to
1 are a standard part of any option. They include such things as
what the underlying asset consists of, the quantity of the
underlying asset to which the options relate, the strike price, the
expiration date, and the ability to exercise the option.
[0069] In order to enter into a Model Option, the buyer and the
seller must also agree on a formula that will be used to calculate
the value of the option 3. Black and Scholes, Whaley, Binomial
Lattice, Trinomial Trees, and Merton's Jump Diffusion are examples
of some of the models that might be used to calculate the value of
a Model Option. The buyer and seller must also agree on either a
specific value or a formula that will be used to determine the
remaining inputs that are necessary for the model they have agreed
to use.
[0070] Assuming for example that the underlying asset is a stock
and the parties have agreed to use the Black and Scholes Model,
they also need to agree on what values they will use for the
risk-free rate, the dividend rate, and the stock's price
volatility. They could agree to use fixed values for each of these
inputs or to agree on a formula that will determine these values.
Thus, they may agree to use the 90-day US Treasury bill yield as
the risk-free rate, the last dividend payment annualized as a
percentage of the current stock price as the dividend rate, and the
annualized standard deviation of the daily change in the underlying
stock's price over the preceding 30 trading days as the
volatility.
[0071] Next the buyer and seller must agree on when the formula
that they have specified will be used to determine valuation. They
can use it to determine the option premium at contract inception,
at each important point between inception and expiration, and at
expiration. They may agree to use the model to determine valuation
during the entire life of the option. Alternatively, they may
decide to use the model to determine the option's value only after
inception. This approach might make sense in the case of employee
stock options, where vesting takes place over a period of years.
Additionally, they may agree to exchange money at various points
over the life of the option in accordance with changes in the value
of the contract so that the contract never needs to be traded or
exercised and that credit risk may be minimized.
Additional Embodiments
[0072] Although the basic methodology for Model Options is
described above, there are numerous embodiments of this concept.
This method can be applied to all types of options on all types of
assets.
[0073] This method can be used both on and off of an options
exchange. In the case of exchange usage, the specifications of each
contract would be predetermined by the exchange and the buyer and
seller would merely agree to trade a particular contract. This
eliminates the need for a buyer and seller to agree on each term
individually.
[0074] Furthermore, this methodology can be used in conjunction
with any other type of option pricing mechanisms at various points
of the options life.
[0075] Conclusion, Ramifications, and Scope of Invention
[0076] From the description above it should be clear that this
method of option valuation satisfies many purposes that can not be
accomplished via traditional options. Incorporating a specific
valuation methodology into an option contract makes option
valuation more understandable, more certain, and less costly. Model
Options help expand option usage by permitting buyers and sellers
to use options in ways that are currently impossible.
[0077] Model Options eliminate the need for the price discovery
function of an exchange. This enables trading on small company
stocks, on long-duration options, and on deep out-of-the-money
options that is not possible presently due to a lack of liquidity,
and concerns about the potential for pricing distortions and
manipulation.
[0078] Model Options eliminate the importance of small speculators
to the price discovery process. This, in turn, lessens the
importance of the credit risk management function that large
exchanges provide. Absent the need for a price discovery function
and a credit risk management function, it is possible for smaller
exchanges consisting of large credit-worthy participants to trade
Model Options with much lower transaction costs.
[0079] Model Options permit the buyer and seller to agree that the
contract will never be exercised and that the buyer will never
force delivery of the underlying asset. This prevents unnecessary
trading since the buyer can receive value without having to
exercise the option or make an offsetting trade to close out a
given trading position.
[0080] By reducing transaction costs, it becomes feasible for large
institutions to buy and sell deep out-of-the-money Model Options
that have very small expected values. Currently, such trading is
infeasible because, at a certain point, the cost of trading exceeds
the expected value of the options.
[0081] By using Model Options to compensate employees for achieving
specific operational or financial targets, companies and employees
can gain the benefits of financial leverage while gaining certainty
over the expense and the value associated with these options.
[0082] By agreeing to a specific formula for determining an
option's value, investors can use Model Options to create more
precise hedges.
[0083] Using Model Options, investors can disaggregate each of the
component values of an option's price and trade each of these
values separately. This is impossible with traditional options.
[0084] Although the description above contains certain specifics,
these should not be construed as limiting the scope of the
invention but as merely providing illustrations of some of the
presently preferred embodiments of this invention. This methodology
can be applied in many ways to all types of options, on all types
of assets and can be used on options that are traded on exchanges
or between two parties directly. Thus the scope of the invention
should be determined by the appended claims and the legal
equivalents, rather than by any particular example described
above.
* * * * *