U.S. patent application number 12/008581 was filed with the patent office on 2008-05-08 for model option contracts.
Invention is credited to Bruce Bradford Thomas.
Application Number | 20080109386 12/008581 |
Document ID | / |
Family ID | 33435638 |
Filed Date | 2008-05-08 |
United States Patent
Application |
20080109386 |
Kind Code |
A1 |
Thomas; Bruce Bradford |
May 8, 2008 |
Model option contracts
Abstract
A method for constructing an option contract so that the option
holder has the right to settle the contract by selling it back to
the option seller at a settlement price determined by a specified
valuation methodology that uses an option pricing model.
Inventors: |
Thomas; Bruce Bradford;
(Trumbull, CT) |
Correspondence
Address: |
Bruce Bradford Thomas
145 Lake Avenue
Trumbull
CT
06611
US
|
Family ID: |
33435638 |
Appl. No.: |
12/008581 |
Filed: |
January 11, 2008 |
Related U.S. Patent Documents
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Application
Number |
Filing Date |
Patent Number |
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10757933 |
Jan 15, 2004 |
|
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12008581 |
Jan 11, 2008 |
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Current U.S.
Class: |
705/400 |
Current CPC
Class: |
G06Q 30/0283 20130101;
G06Q 40/06 20130101; G06Q 40/04 20130101; G06Q 40/00 20130101 |
Class at
Publication: |
705/400 |
International
Class: |
G06Q 40/00 20060101
G06Q040/00 |
Claims
1. A method for determining a Model Option Contract's settlement
price, comprising the steps of: a. using said Model Option
Contract's specified valuation methodology to identify which option
pricing model and input values must be used to determine said
settlement price; and b. using an information system, said Model
Option Contract's basic option terms, and said input values to run
said option pricing model to determine said settlement price in
accordance with said specified valuation methodology.
2. The method of claim 1 wherein said Model Option Contract's value
is derived from any type of corporeal personal property.
3. The method of claim 1 wherein said Model Option Contract's value
is derived from any type of equity security.
4. The method of claim 1 wherein said Model Option Contract's value
is derived from any type of debt instrument.
5. The method of claim 1 wherein said Model Option Contract's value
is derived from any type of derivative contract.
6. The method of claim 1 wherein said Model Option Contract's value
is derived from any type of real property.
7. The method of claim 1 wherein said Model Option Contract cannot
be settled by forcing delivery of an underlying asset.
8. The method of claim 1 wherein said basic option terms are
specified by referencing another option contract.
9. A method for constructing a compensation option and determining
a settlement price for said option, comprising the steps of: a.
specifying basic option terms; b. expressing a right to settle said
compensation option at a price determined by a specified valuation
methodology that uses an option pricing model; c. incorporating
said basic option terms, said right to settle, and said specified
valuation methodology in said compensation option; and d. using an
information system to run said option pricing model to determine
said settlement price in accordance with said specified valuation
methodology.
10. The method of claim 9 wherein said compensation option derives
its value from any type of equity security.
11. The method of claim 9 wherein said compensation option derives
its value from any type of debt instrument.
12. The method of claim 9 wherein said compensation option derives
its value from any type of derivative contract.
13. A method for constructing a contract that will be listed on an
exchange and determining a settlement price for said contract,
comprising the steps of: a. specifying basic option terms; b.
expressing a right to settle said contract at a price determined by
a specified valuation methodology that uses an option pricing
model; c. incorporating said basic option terms, said right to
settle, and said specified valuation methodology in said contract;
d. using an information system to run said option pricing model to
determine said settlement price in accordance with said specified
valuation methodology.
14. The method of claim 13 wherein said contract derives its value
from any type of equity security.
15. The method of claim 13 wherein said contract derives its value
from any type of debt instrument.
16. The method of claim 13 wherein said contract derives its value
from any type of derivative contract.
17. The method of claim 13 wherein said contract derives its value
from any type of real property.
18. The method of claim 13 wherein said contract cannot be settled
by forcing delivery of an underlying asset.
19. The method of claim 13 wherein said basic option terms are
specified by referencing another option contract.
20. The method of claim 13 that further comprises the step of: a.
using an information system to list said contract for trade, match
buyers with sellers, and store transaction information.
Description
CROSS-REFERENCE TO RELATED APPLICATIONS
[0001] This application is a continuation of nonprovisional patent
application Ser. No. 10/757,933 filed Jan. 15, 2004 entitled "Model
Options" by the present inventor, now abandoned.
FEDERALLY SPONSORED RESEARCH
[0002] Not Applicable
SEQUENCE LISTING OR PROGRAM
[0003] Not Applicable
BACKGROUND OF THE INVENTION
[0004] 1. Field of Invention
[0005] This invention relates to constructing and settling option
contracts.
[0006] 2. Background of the Invention
Options
[0007] 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. The life of an option is called the
contract's term and is determined by the expiration date of the
contract. The payment that is exchanged for this right is called
the option premium. If the option holder does not exercise his
right prior to the contract's expiration, the option expires
worthless.
[0008] 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.
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, it is said to be "in-the-money." "Deep in-the-money" options
refer to options that have a substantially positive intrinsic
value.
[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 known as the
"time value" of an option, and it 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.
Financial Leverage
[0012] 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 call options on the
stock.
[0013] 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 call 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.
[0014] 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 financially
efficient for the speculator to buy options than to buy the
underlying stock.
Option Usage
[0015] 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. Exchanges may be set up and function in many different ways.
For example, they can act as a counterparty between buyers and
sellers or they can merely provide information that enables buyers
and sellers to trade directly with one another.
[0016] 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.
[0017] 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.
[0018] 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.
Options Classified by Exercise Features
[0019] There are three main ways in which the exercise feature of
options is generally structured. American style options enable the
holder to exercise the option at any point prior to the expiration
date. European style options only enable the holder to exercise the
option on the expiration date. Burmudian options may be exercised
at any one of various pre-set points during the life of the
option.
Options as Compensation
[0020] Companies routinely grant options as compensation (i.e.
compensation options) in exchange for work or other services. This
is commonly referred to as an "incentive stock option" since it is
often granted to corporate managers and employees as a means of
motivating them to achieve certain financial and operational
objectives. Compensation options are usually granted at a strike
price that is at 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.
Option Pricing Models
[0021] 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 over time,
and other models have been developed to correct certain perceived
weaknesses of the Black and Scholes Model.
[0022] 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.
[0023] 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 far more calculations. Calculation speed
is critically important because market prices can change very
quickly, and even the most advanced computers may have trouble
calculating theoretical values fast enough to keep up with these
changes.
[0024] Despite the different techniques that they employ, the
models require essentially the same inputs to create an option's
theoretical value. These inputs are: whether the option is a put or
call, 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.
Uncertain Option Values
[0025] 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.
[0026] 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 out-of-the-money contracts.
[0027] 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.
[0028] 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.
[0029] 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.
Implied Volatility
[0030] 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.
[0031] 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.
[0032] 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.
New Approach Needed
[0033] 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.
[0034] 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.
[0035] 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.
[0036] 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 choose 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?
[0037] 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.
[0038] Meanwhile employees may not attribute much or any value to
the options that they are granted because they have may not have
fully vested, typically have no intrinsic value, and cannot be
sold. Moreover, most employees have no understanding of option
valuation models.
[0039] 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.
[0040] 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.
OBJECTS AND ADVANTAGES
[0041] 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 Option Contracts objectify the uncertainty associated with
the pricing of options using an agreed value approach. Model Option
Contracts 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.
[0042] In the case of compensation options, where the contract is
granted in exchange for work or other services, companies and
employees can use Model Option Contracts to bridge the gap that
exists between the option expense that the grantor must recognize
in its books and records and the value that employees think the
option grants have. To a large extent this "valuation gap" is
caused by the holder's inability to see a ready market price at
which someone will buy the option from them so they tend to ignore
the time value of the options granted.
[0043] Since most compensation options are granted with little or
no intrinsic value, assessing the time value of the options granted
is critically important to understanding the overall value of these
options. By structuring the option as a model option, the company
creates a price that is visible to the grantee of how much the
options are worth. Using this business method, companies can
provide their employees with continuous prices at which they may
sell their options back to the company.
[0044] With Model Options, buyers and sellers no longer need to be
wary of long-duration, 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.
[0045] Since price discovery is not necessary for Model Option
Contracts, 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 would have to pay trading fees that are too large in
relation to what the underlying options are worth to be
economical.
[0046] Model Option Contracts facilitate option trading 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.
[0047] Model Option Contracts 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 a given
counterparty's liability exceeds a certain threshold.
[0048] Unlike traditional options, Model Option Contracts can be
structured so that they do not allow the holder to force delivery
of the underlying asset. Instead, the parties can structure a Model
Option Contract so that the holder is only able to demand a cash
payment from the option seller at a price that is determined by the
valuation methodology that is embedded in the option contract.
[0049] This feature reduces transaction costs and may be especially
useful when option traders have no real interest in transferring
the underlying property but just want to profit or minimize losses
associated with changes in value of that property. For example,
many option holders are not interested in converting the option
into the underlying property (in the case of a call option) or
transferring the underlying property to the option seller (in the
case of a put option).
[0050] Another useful feature of Model Option Contracts 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
structure Model Option Contracts so that they are effectively only
trading just the volatility component of an option, or just the
dividend yield component.
[0051] 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 OF THE INVENTION
[0052] A Model Option Contract ("Model Option") is a new type of
option contract that gives the holder the right to settle the
contract by selling it back to the option seller at a price
determined by a valuation methodology that is specified in the
contract. In effect, this is a way of embedding a put option into
an option contract since the option holder has the right to put the
option contract back to the option seller for a cash value via a
settlement right that is specified in the option contract.
[0053] Constructing a Model Option Contract requires specification
in the contract of: basic option terms such as whether it is a put
or call, the underlying asset, a strike price, an expiration date
or contract term, and the type of exercise that is allowed
(American, European, etc.); the additional right to settle the
contract by selling it back to the option seller; and a valuation
methodology that will be used to determine the value of this
additional right.
[0054] The additional right to settle the contract by selling it
back to the option seller during the life of the contract may be
structured in countless ways. A Model Option Contract may give the
option holder the right to sell the contract back at a preset point
or points. It may grant this right continuously over the life of
the contract. A Model Option Contract may give this additional
settlement right continuously over the life of the contract unless
certain specified events occur. Alternatively, the contract may
only give this right only upon the occurrence of certain specified
conditions.
[0055] In the case of options used as compensation, personal
conditions pertaining to the holder might be specified such as age,
disability, loss of a loved one, etc. Alternatively, certain
corporate conditions might trigger this right or prevent the holder
from exercising this right including the possibility of a hostile
takeover, the company's bankruptcy filing, or the advent of some
other financial event. Other more general conditions that might be
used to trigger this additional settlement right or nullify it
would include changes in market indicia such as volume of trades,
interest rate changes, etc.
[0056] The valuation methodology employed in a Model Option must
include a description of an option pricing model (such as the Black
and Scholes, the binomial, etc.) and how the input values necessary
to run the option pricing model will be derived (i.e., the
risk-free rate of interest, the volatility of the underlying asset
price, the dividend rate, etc.). An information system is necessary
to implement the valuation methodology given the complexity of the
mathematical calculations employed and the need for accuracy and
computational speed.
[0057] Model Option Contracts can be used in many different ways in
conjunction with the market for traditional options or even when
there is no market for traditional options on the underlying asset
or over a specific time horizon.
BRIEF DESCRIPTION OF THE DRAWINGS
[0058] FIG. 1 is a table comparing the important contractual
features of a Model Option with a traditional option.
[0059] FIG. 2 demonstrates that the time value of the settlement
price of a Model Option may be significantly different than the
time value of a traditional option even when that option is on a
very large company's stock and the traditional option is actively
traded.
[0060] FIG. 3 is a flowchart that shows how a buyer and seller
might use this business method to construct and execute a Model
Option Contract and determine its settlement price.
[0061] FIG. 4 is a flowchart that shows how a company might use
this business method to construct a Model Option Contract used for
compensation purposes and determine its settlement price.
[0062] FIG. 5 is a flowchart that shows how an exchange could use
this business method to construct and trade a Model Option Contract
and determine its settlement price.
DETAILED DESCRIPTION
FIGS. 1-5--Preferred Embodiments
[0063] The following detailed description discloses various
embodiments and features of the invention. These embodiments and
features are meant to be exemplary and not limiting.
DEFINITIONS
[0064] The definitions provided below are to be applied to their
respective terms or phrases as used herein unless the context of a
given particular use of a given term or phrase clearly indicates
otherwise.
[0065] The term "contract owner" refers to the owner of the Model
Option Contract (also referred to as a "Model Option").
[0066] The term "right to settle" and "settlement right" refer to
the Model Option Contract owner's right to settle the contract by
selling it back to the party that sold them the Model Option
Contract.
[0067] The term "settlement price" refers to the price at which the
Model Option Contract owner may settle the contract by selling it
back to the option seller. The term "basic option terms" refers to
the terms that must be included in an option contract. These terms
are a standard part of any option contract and include such things
as whether the option is a put or call, a description of the
underlying asset, the strike price, the expiration date or contract
term, and the holder's ability to exercise the option (American,
European, Bermudian, etc.). Basic option terms may be described in
the Model Option Contract itself or might include such
specification by referencing the terms of another option
contract.
[0068] The term "specified valuation methodology" refers to the
valuation methodology that is described in a Model Option Contract
and used to determine the settlement price. The specified valuation
methodology included in a Model Option consists of two parts: a
description of an option pricing model; and a description of how
each of the input values, necessary to run the option pricing
model, will be derived.
[0069] The term "option pricing model" refers to any recognized and
accepted mathematical model that is used to develop the theoretical
value of an option. Black and Scholes, Whaley, Binomial Lattice,
Trinomial Trees, and Merton's Jump Diffusion are examples of option
pricing models. At least one option pricing model must be specified
in a Model Option Contract, as such a model is used to determine
the settlement price of a Model Option. More than one option
pricing model may be specified in a Model Option Contract so long
as it is clear under what circumstances each model will be used and
how each model will be used to determine the settlement price.
[0070] The term "input values" refers to each of the values that
that are required to run the option pricing model that must also be
included in the specified valuation methodology such as the
risk-free rate of interest, the volatility of the underlying asset
price, the dividend rate, etc. These values would not be
determinable from the Model Option contract wording if it were not
for the description in the specified valuation methodology. The
other values necessary to run the option pricing model are obvious
based on the contract wording that specifies the basic option
terms.
[0071] The term "information system" refers to one or more
computers, servers, input devices, output devices, data storage
devices, telecommunications equipment and software. Information
systems may communicate with other information systems via
telecommunications means, such as the Internet. Information systems
may also communicate with persons via input/output devices. Persons
may communicate with other persons using information systems.
[0072] The term "compensation option" refers to an option that a
company grants in exchange for work or other services.
[0073] The term "company" refers to any organization that is set up
to make profits and includes stock companies, partnerships, limited
liability companies, etc.
[0074] The term "exchange" refers to a place or mechanism that
facilitates the trading of options. An exchange can be a physical
location or an electronic mechanism where trading takes place or
where information about trading is provided. An exchange may act as
counterparty between buyers and sellers or it can merely provide
information that enables buyers and sellers to trade directly with
one another.
[0075] The term "personal property" includes corporeal personal
property and incorporeal personal property.
[0076] The term "corporeal personal property" refers to
commodities, animals, furniture, collectibles, merchandise,
inventory, etc.
[0077] The term "incorporeal personal property" refers to financial
instruments and intellectual property.
[0078] The term "financial instrument" includes any type of equity
security, debt instrument, or derivative contract.
[0079] The term "equity security" refers to any ownership interest
in a company including common stocks, preferred stocks, partnership
interests, interest in a limited liability corporation, etc.
[0080] The term "debt instrument" refers to any evidence of
indebtedness such as bills, notes, bonds, certificates of deposit,
banker's acceptances, commercial paper, etc. The term "derivative
contract" refers to any contract that derives its value from an
underlying financial asset, index or other type of investment
including futures, forwards, index-linked securities, etc.
[0081] The term "intellectual property" refers to any intellectual
property right such as patents, copyrights, trademarks, etc.
[0082] The term "real property" refers to land and all property
attached to the land such as trees, buildings, and
improvements.
Contract Overview
[0083] An overview of the differences between a Model Option and a
traditional option is shown in FIG. 1. The table shows that the
basic option terms that must be specified in a traditional option
must also be specified in a Model Option.
[0084] In a traditional option, the option holder may be able to
exercise the option and force delivery of the underlying asset at
any time, at set intervals, or only at the expiration of the
contract. Model Option Contracts may be structured in a similar
fashion, but they may also be structured so that they do not permit
the delivery of the underlying asset.
[0085] This additional limitation is possible because the Model
Option holder also has a right to settle the contract by selling it
back to the option seller at a settlement price that is determined
by using the specified valuation methodology. There is no such
right in a traditional option.
[0086] The value of a traditional option is determined by the
market price for the underlying asset (the intrinsic value) or the
value at which the option contract can be traded to another party,
assuming that the option holder has the right to trade the contract
and that there is some other party willing to buy the contract.
Because Model Option Contracts give the option holder an additional
right to settle the contract by selling it back to the option
seller, the value of a Model Option is also determined by the
specified valuation methodology incorporated within it. This
feature enables an option holder to capture the time value of an
option regardless of whether there is a third party willing to buy
the option or whether the option holder has the right to sell the
contract to a third party.
[0087] This feature of a Model Option Contract is operable because
it includes a specified valuation methodology will be used to
determine the contract's settlement price. As shown in the table in
FIG. 1, traditional options do not include this information.
[0088] The specified valuation methodology must state what option
pricing model will be used and must include a description of how
each of the unobvious inputs to the model will be determined. For
example, it is clear whether an option is a put or a call, what the
strike price is, and what the contract term is based on the
contract wording. However, it may not be obvious what to use as the
other inputs to the option pricing model.
[0089] The specification for these inputs to the option valuation
model may be described by stating a fixed value, a formula, or a
reference to some other metric. So long as it is definite how these
inputs will be determined, the Model Option Contract will be
legally valid and the parties will be able to determine the
settlement price.
[0090] 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.
For example, they may agree to use the 90-day US Treasury bill
yield on the valuation date 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.
[0091] There are countless ways of specifying each of these input
values. For example, the volatility input to the Black and Scholes
Model could be specified as a fixed value such as 30%, it could be
specified as a formula that captures the underlying asset's
historical price variations, it could be specified as a formula
that captures the historical price variations of some other indicia
that serves as a proxy for the underlying asset; and it could also
specify a formula and then increase or decrease that number to some
degree. If the underlying asset is a tech stock, the historical
volatility of a tech stock index might be referenced. One could
also specify the volatility input by describing a formula that
would calculate implied volatility for the underlying asset or some
other relevant benchmark.
[0092] The buyer and seller must agree on how to structure the
Model Option Contract's right to settle. They may agree that the
option holder (the buyer) will have this settlement right
continuously over the life of the contract, at each important point
between inception and expiration, or at the contract's expiration.
They may also agree that this right is only present if certain
conditions are met, as more fully described above in the Summary
section.
[0093] Another feature of a Model Option that distinguishes it from
a traditional option is that, by manipulating the valuation
methodology, the time value can be decoupled into its component
parts. This enables options traders to trade each component value
separately. If for example they were only interested in hedging or
speculating about the volatility or the dividend rate it would be
much more effective and efficient to trade just that component of
an option's value.
Comparing Option Performance
[0094] FIG. 2 compares the time value of a General Motors put with
a strike price of $30 and an expiration date of Jun. 18, 2005 with
the time value of the settlement price of a Model Option with
similar basic option terms. The Model Option Contract specified
that the right to put the contract back to the option seller would
be valued by using the Black and Scholes option pricing model; that
2.8% would be used as the risk-free rate (this was the three month
Treasury yield at the beginning of the contract); that 6.25% would
be used as the dividend yield; and that the volatility input to the
model would be based on the preceding year's stock price
movements.
[0095] Volatility was calculated by taking the standard deviation
of the log value of the ratio of daily price change in GM stock for
the preceding 252 trading days and multiplying that number by the
square root of 252. This calculation was updated each day based on
the price changes in the underlying stock over the preceding 252
days.
[0096] Despite the fact that the time value of the settlement right
in the Model Option and the time value of the traditional option
move in similar directions and end up with the same value at
expiration, the paths they take to this destination are different.
The traditional option's time value is determined by the option
market's perception of where General Motor's stock would be by the
expiration date. The time value of the Model Option's settlement
value is based on various input factors, the most important of
which is the historical volatility of the underlying stock price.
As the expiration date approaches, the time value of both options
diminishes to the point where it becomes inconsequential.
[0097] Based on the chart one can see that the difference between
the two options' time value would have been significant to both of
the parties. The average difference over this time horizon,
measured in terms of the initial price of the option, was 60%, but
there were eleven days when the difference was over 100%.
[0098] This difference is the result of the prevailing market
opinion that GM's stock price would fall over this period. To
account for this sentiment in terms of an option model, one would
say that "implied volatility" of the traditional option was much
higher than historical volatility that was used to value the
settlement right of the Model Option. However, since the settlement
right of the Model Option is based on the historical price
volatility, it never incorporates this current market bias.
[0099] The Model Option that was specified in this example was used
for illustrative purposes only. The volatility input value
specified in the Model Option might have been expressed in many
different ways, and some of these ways might have made the cash
settlement feature of a Model Option worth more than the
traditional option. In this case, the volatility input value of the
Model Option would be greater than the volatility implied by the
market.
Operation of the Invention--Bilateral Contract Construction and
Valuation
[0100] An overview of how a buyer and seller might use this method
to construct and execute a Model Option Contract and determine its
settlement price is shown in FIG. 3. To enter into a Model Option
Contract, a buyer and seller must first specify and agree on the
basic option terms in the form of a contract 1.
[0101] Next, the buyer and seller must include a provision in the
contract that gives the option holder the right to settle the
contract by selling it back to the option seller at a settlement
price determined by a specified valuation methodology that uses an
option pricing model 3.
[0102] If they can agree on these terms then the buyer will pay the
seller an option premium in exchange for the specified contract 4.
If they are unable to agree on the basic option terms, the
settlement right, the valuation methodology, and the option
premium, they will not enter into a Model Option Contract 2.
[0103] Finally, an information system is used to determine the
settlement price 5. An information system is necessary to implement
the valuation methodology and run the option pricing model given
the complexity of the mathematical calculations employed and the
need for accuracy and computational speed. In practice, both the
option seller and the option holder may use their own information
systems to perform this calculation. Knowing the price at which the
contract can be sold, the option holder may decide to exercise the
settlement right and sell the Model Option Contract back to the
option seller.
Operation of the Invention--Model Option Used as Compensation
[0104] FIG. 4 is a flowchart showing how a company would use this
business method to grant a compensation option and how it would
determine the settlement price of the Model Option it conveys.
First, the company specifies basic option terms in the form of a
contract 1. Next the company specifies in the contract that the
contract holder will have the right to settle the contract by
selling it back to the company at a settlement price determined by
a specified valuation methodology that uses an option pricing model
3. This is more fully described above in the Summary section and in
the description pertaining to FIG. 3.
[0105] If the company is satisfied with all of these terms, it
grants the Model Option to another party in return for future
services 4. If it is not satisfied, it does not grant the Model
Option 2.
[0106] Assuming a grant is made, an information system is used to
determine the settlement price using the specified valuation
methodology 5. An information system is necessary to implement the
valuation methodology and run the option pricing model given the
complexity of the mathematical calculations employed and the need
for accuracy and computational speed.
[0107] The process shown in FIG. 4 is very similar to the one shown
in FIG. 3, but it more accurately describes the process as
pertaining to the development, issuance, and valuation of a
unilateral contract devised to compensate another party for
services. In practice, companies typically specify that such
contracts are "vested" over some future period of time.
[0108] Companies use vesting to ensure that the grantees only get
the full value of the option over a period of months or years of
future service. Also, options used for compensation are not
typically transferable to a third party, further limiting the
rights of the grantee to capture the full time value of the option
grant. Each of these contractual limitations may also be employed
in Model Options that are constructed as compensation options.
Operation of the Invention--Exchange Traded Model Option
[0109] FIG. 5 shows how an exchange would construct a Model Option
Contract, list it for trade, match buyers with sellers, store
transaction information and determine a settlement price for the
contract. First, the exchange must specify basic option terms in
the form of a contract 1. Next it must specify in the contract that
the contract holder will have the right to settle the contract by
selling it back to the option seller at a settlement price
determined by a specified valuation methodology that uses an option
pricing model 3. This is more fully described above in the Summary
section and in the description pertaining to FIG. 3.
[0110] Although the exchange is solely responsible for the
development of the Model Option Contract, in practice, it will
solicit feedback from its members and other option users to
determine the features that are most attractive and acceptable. In
effect, the specifications of each contract would be predetermined
by the exchange, and the buyer and seller would merely agree to
trade a particular contract that is listed by the exchange. This
eliminates the need for a buyer and seller to agree on each term
individually.
[0111] The exchange uses at least one information system to list
the Model Option Contract for trade, match buyers with sellers,
effectuate the option purchase and sale, and to store the
transaction information 4. If the exchange is not able to develop
satisfactory terms, it does not list or exchange the Model Option
Contract 2.
[0112] If the exchange is able to list and transact a Model Option
Contract, an information system is necessary to implement the
specified valuation methodology and determine the settlement price
5. An information system is necessary to given the complexity of
the mathematical calculations employed and the need for accuracy
and computational speed.
[0113] Depending on the functions that the exchange performs, it
may be a counterparty on each of the trades or it may only
facilitate trade between its members. Either way, determining this
price is very valuable from a risk management perspective since it
enables parties to monitor and manage their counterparty credit
risk.
Additional Embodiments
[0114] Although three basic ways of constructing a Model Option
Contract and determining its settlement price are described above,
Model Options can be structured in countless ways by changing the
underlying asset that is referenced, the strike price, the
expiration date, the option holder's ability to exercise the
option, the option holder's right to settle the contract by selling
it back to the seller, and the valuation methodology employed.
[0115] Model Option Contracts can reference any type of real or
personal property. With Model Options, the contract can eliminate
the option holder's ability to force delivery of the underlying
asset since the contract holder can force the contract seller to
pay the specified cash payment to extinguish the contract. Model
Options can be structured so that each component of option
valuation may be traded separately.
[0116] Additionally, Model Option Contracts can be structured so
that they form one or more provisions in some other type of
contract, such as a purchase and sale agreement, a lease, an equity
or security, instrument of indebtedness, a futures contract, a
forward contract, an annuity, etc.
CONCLUSION, RAMIFICATIONS, AND SCOPE OF INVENTION
[0117] From the description above it should be clear that this
method of constructing an option contract and determining a
settlement price satisfies many purposes that can not be
accomplished by constructing and valuing options in the traditional
way. Incorporating a specified valuation methodology and a
settlement right into an option contract makes option valuation
more understandable, more certain, and less costly. Model Option
Contracts help expand option usage by permitting buyers and sellers
to use options in ways that are currently impossible.
[0118] Model Option Contracts 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.
[0119] Model Option Contracts 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 Option Contracts with much lower transaction costs.
[0120] Model Option Contracts permit the buyer and seller to agree
that the contract will never be exercised in the traditional way by
forcing delivery of the underlying asset. This prevents unnecessary
trading since the buyer can receive value without having to force
delivery of the underlying asset or engage in other trading to
close out or rebalance a given trading position.
[0121] By reducing transaction costs, it becomes feasible for large
institutions to buy and sell deep out-of-the-money Model Option
Contracts 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.
[0122] By using Model Option Contracts as compensation for services
(a compensation option), companies and individuals can gain the
benefits of financial leverage while gaining certainty over the
expense and the value associated with these options.
[0123] By agreeing to a specific formula for determining an
option's value, investors can use Model Option Contracts to create
more precise hedges.
[0124] Using Model Option Contracts, 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.
[0125] 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.
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