options everywhere
In the aftermath of one of the most severe economic crises ever recorded, the public perception of options and futures has changed significantly. These instruments are now viewed as dangerous financial tools that come with high leverage ratios.
This perception is based on a misunderstanding. Options and forwards contracts are not new financial innovations. They have been with us since the inception of the notion of a limited liability company: Equity has an option-like pay-off structure due to the limited liability clause.
Here is an even more mundane example: Every supply and purchase agreement is essentially a forward contract where two parties agree on a quantity, a price and a delivery date. (In case the buyer side does not post any collateral, the leverage ratio is effectively infinite!) Sometimes these agreements even contain embedded options. This turns them into instruments far more complicated than the financial agreements that are currently the subject of public fear. Here are two examples of such embedded options:
- A right to buy additional quantities over the base quantity at a price that is set equal to or below the contract price.
- A right to postpone the delivery to a future date upon the payment of a previously determined penalty fee.
This perception is based on a misunderstanding. Options and forwards contracts are not new financial innovations. They have been with us since the inception of the notion of a limited liability company: Equity has an option-like pay-off structure due to the limited liability clause.
Here is an even more mundane example: Every supply and purchase agreement is essentially a forward contract where two parties agree on a quantity, a price and a delivery date. (In case the buyer side does not post any collateral, the leverage ratio is effectively infinite!) Sometimes these agreements even contain embedded options. This turns them into instruments far more complicated than the financial agreements that are currently the subject of public fear. Here are two examples of such embedded options:
- A right to buy additional quantities over the base quantity at a price that is set equal to or below the contract price.
- A right to postpone the delivery to a future date upon the payment of a previously determined penalty fee.
