Tuesday, March 4, 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (4)

Option Player is a piker. He wants to make it big in the markets but has neither Arbitrageur’s acumen nor Lender’s capital. The combination makes him vulnerable to manipulation. Against this backdrop, Arbitrageur and Lender appear at his door. The arbitrageur is a descendent of the Music Man and knows the Alpha and Omega of salesmanship, beginning with sympathizing:

“I understand you are in the market to invest but you are in a jam because you have no money. Indeed $50 is a great sum. Who has that kind of money these days?"

Option Player nods in approval.

Arbitrageur continues: “But look! Perhaps you are not approaching this thing from the right angle. Allow me to show you a way that you could profit from a rise in the stock without owning it. I know it sounds too good to be true but this one is good and true!

“The stock you want to buy is $50. One year from now, it could rise to $60 or fall to $40. Here is my offer. One year from now, if the stock is $60, I would pay you $10, which is the difference between $60 and the current price. If the stock is under $40, you pay me nothing. All you need for this once-in-a-lifetime opportunity is $5 which you have to pay me now.”

Option Player is tempted but remains skeptical. He remembers Melville from The Confidence Man that being asked to believe in something is being set up. But perhaps Melville was getting cantankerous at old age, he tells himself and mentally regurgitates the sale brochure of exchanges and brokerage houses: Options are the revolutionary products of the modern financial markets. The best and the brightest of finance have attested to their power and fairness. So big and complex a game could not be fixed.

He signals his interest by inquiring about the size of the payment.

“The prepayment is very small, merely $5” says Arbitrageur. “I have always believed in giving the little guy a chance. (It is so American.)

- You mean $5 is the only money I will have to pay even if the stock price goes down to $40? And I will still get paid $10 if it goes up to $60.

“Absolutely,” Arbitrageur ensures him. “In return for $5 upfront payment, all your future obligations will be extinguished. You will never have to pay a dime no matter how low the stock drops. Your upside potential would remain unlimited. The calculation of your $5 prepayment, by the way, is due to three eminent scholars who won fame and fortune for their discovery. So it is fair and objective. If you accept this bet, you could say that you buy a call option on the stock where you will have the right, but not the obligation, to buy the stock. ” (Again, he emphasizes the right but not the obligation.)

Option Player is sold. He pays $5 to Arbitrageur who takes it to Lender as the proof of his – Arbitrageur’s – having the required $5 “equity.” The lender pays the arbitrageur $20. With $25 in hand, Arbitrageur buys ½ share of stock. The loop is closed.

Lender has understood everything. He has one question: “How did you come up with the definition of option as the right to buy or sell?” he asks Arbitrageur.

- Well, it is the standard definition of option repeated untold number of times in markets, business schools, finance seminars, scholarly papers, dissertations and professional journals for decades. I myself have taught it to many students.

Lender is flabbergasted: “But that is not what an option is!”

Arbitrageur is even more surprised: “What do you mean? Then what is an option?”

Lender explains: “An option is a right to default. You said it so yourself to Option Player except that you did not listen to what you were saying. The ‘price’ of your option is nothing but the value of a credit loss – the loss that I had to absorb had I lent you $25 and stock had dropped to $40. It is also the cost of default of Option Player that you have to absorb if the stock drops to $40, as in that case he would not have to pay you the full amount of loss, $50 – 40 = $10. Of course, you might not care about this scenario because you benefit from the trade in a different way but that does not make an option any less a right to default. It is truly strange that this simple concept has escaped comprehension for so long.”

Arbitrageur understands what the lender is saying but cannot bring himself to agree: “I guess what you are saying is one way of looking at the problem. But thousands of finance professors, students, researchers and the Wall Street ‘quants’ have worked on this since 1973. They all believe – nay, know – options to be right to buy or sell the stock. In fact, that is how options are valued, as you just saw.”

“Yes, and that is the puzzlement,” Lender answers with a smile. “What I saw is that you calculated the dollar amount of your shortfall in the down scenario of stock and transferred it through the call option to Option Player. That did not give him any right to buy or sell. It merely insulated him against a fall in the stock price. If you did not mean to mislead the options buyer you must be one confused fellow yourself. And by the way, defining an option as a right to default is not a way of looking at it. It is the only way. Any other way is misreading and misunderstanding the situation in the same way that describing the solar system with the sun in any place but the center would be incorrect."

After this Socratic discourse, the protagonists return to the world of abstract finance, having shown us the “nature” of $5 in our example. It is the potential loss of speculative capital that is financed by speculative capital through the derivatives market.

Will return with Part 5.

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