Money and loans

Gains from specialization and division of labor

admin — Fri, 09 Oct 2009 07:29:33 +0000

Businesses can achieve higher output levels and greater productivity from their workers through specialization and division of labor. More than 200 years ago, Adam Smith noted the importance of this factor. Observing the operation of a pin manufacturer, Smith noted that when each worker specialized in a separate function needed to make pins, 10 workers together were able to produce 48,000 pins per day, or 4,800 pins per worker. Smith doubted an individual worker could produce even 20 pins per day working alone from start to finish on each pin.
The division of labor separates production tasks into a series of related operations. Each worker performs one or a few of perhaps hundreds of tasks necessary to produce something. This process makes it possible to assign different tasks to those individuals who are able to accomplish them most efficiently (that is, at the lowest cost). Furthermore, a worker who specializes in just one narrow area becomes more experienced and more skilled in that task over time.
Trading partners can also benefit from specialization and the division of labor. The law of comparative advantage developed in the early 1800s by the great English economist David Ricardo, explains why this is true. The law of comparative advantage states that the total output of a group of individuals, an entire economy, or a group of nations will be greatest when the output of each good is produced by the person (or firm) with the lowest opportunity cost.
Comparative advantage applies to trade among individuals, business firms, regions, and even nations. When trading partners are able to use more of their time and resources to produce the things each is best at, they will be able to produce more together than would otherwise have been possible. In turn, the mutual gains they get from trading will result in higher levels of income for each. It’s a win-win situation for both.
If a good or service can be obtained more economically through trade, it makes sense to get it that way rather than producing it for yourself. For example, even though most doctors might be good at record keeping and arranging appointments, it’s generally better for them to hire someone to perform these services for them. That’s because the time doctors spend keeping records is time they could have spent seeing patients. The revenue forgone as a result of seeing fewer patients would be greater than the cost of hiring the worker. The issue is not whether doctors are better record keepers than the assistants they could hire, but rather how they should use their time most efficiently.
If you think about it, the law of comparative advantage is common sense. If someone else is willing to supply you with a good at a lower cost than you can produce it yourself, doesn’t it make sense to trade for it and use your time and resources to produce more of the things you can produce most efficiently? Consider the situation of Andrea, an attorney who earns $100 per hour providing legal services. She has several documents that need to be typed, and she is thinking about hiring a typist earning $15 per hour to do it. Andrea is an excellent typist, much faster than the prospective employee. She could do the job in 20 hours, whereas the typist would take 40 hours.
Because of her greater typing speed, some might think Andrea should handle the job herself. This is not the case. If she types the documents, the job will cost her $2,000-the opportunity cost of 20 hours of practicing law at $100 per hour. Alternatively, the cost of having the documents typed by the typist is only $600 (40 hours at $15 per hour). Andrea’s comparative advantage lies in practicing law. By hiring the typist, she will increase her own productivity and make more money.
The implications of the law of comparative advantage are universal. Any group will be able to produce more output from its available resources when each good or service is produced by the person with the lowest opportunity cost. This insight is particularly important in understanding the way a market economy works. Purposeful decision making indicates that buyers will try to get the most for their money. They will not knowingly choose a high-cost option when a lower-cost alternative is available. This places low-cost suppliers at a competitive advantage. Thus, they will generally survive and prosper in a market economy. As a result, the production of goods and resources will naturally tend to be allocated according to comparative advantage.
Most people recognize that Americans benefit from trade among the nation’s 50 states. For example, the residents of Nebraska and Florida are able to produce a larger joint output and achieve higher income levels when Nebraskans specialize in producing wheat and other grain products, and Floridians specialize in producing oranges and other citrus products. The same is true for trade among nations. Like Nebraskans and Floridians, people in different nations will be better off if they specialize in the goods and services they can produce at a low cost and trade them for goods they produce at a high cost.

Strategic Options (Real Options)

admin — Fri, 02 Oct 2009 07:28:10 +0000

Thinking of project option features in capital budgeting is essential. For example, ﬁrms have A real option depends not on an underlying ﬁnancial asset (such as a stock), but on an underlying real asset.
the ability to shut down production if the market price of their output product were to fall. That is, a project that allows management to curtail production when it is unproﬁtable is the equivalent of a call option with a strike price that depends on the price of the output good. Such options are called real options, because their exercise depends on the value of “real” assets, rather than on the value of ﬁnancial assets. The house with a mortgage was a real option.
If the base asset is a stock price in the future, we know the underlying stock price today and that the rate of return until expiration is roughly normally distributed. If the underlying base asset value (e.g., the house or the ﬁrm’s output product or the ﬁrm’s input product [e.g., gold or oil]) is similarly roughly normally distributed, we can even use the Black-Scholes formula to value the derivative asset. Doing so replaces the need to estimate the appropriate cost of capital, E ( r ), on the project with the need to estimate the variance, σ ( r ). (Usually, estimating volatility is easier and more reliable.)
However, the most important aspect of real options is to recognize their presence, not the method of valuation. Whether the B-S Formula is used to avoid estimating the appropriate cost of capital, or a CAPM type formula with an expected cash ﬂow estimate is used to obtain the appropriate cost of capital, is of relatively less importance. The big mistakes that managers often commit is that they fail to value the real option at all.

Synthetic Securities

admin — Sat, 26 Sep 2009 07:27:06 +0000

A different way to look at arbitrage relationships is to recognize that they deﬁne securities. That is, even if a put option were not available in the ﬁnancial markets, it would be easy for you to manufacture one (assuming minimal transaction costs, of course). For example, return to the put-call parity relationship. It states that European options have the relationship C0 ( K ) = P0 ( K ) + S0 − PV0 ( K ) ⇐⇒ P0 ( K ) = C0 ( K ) − S0 + PV0 ( K ). Instead of purchasing one put option, you can purchase one call option, short one stock, and invest the present value of the strike price in an account providing the risk-free rate of interest would pay. You would receive the same payoffs as if you had purchased the put option itself. Therefore, you have manufactured for yourself a synthetic put option.
Creating synthetic securities has become big business for Wall Street. For example, a company owning gas stations may wish to obtain an option to purchase 10,000 barrels of crude oil in 10 years at a price of $50 per barrel. A Wall Street supplier of such call options models the price of oil, and determines the appropriate value of a synthetic call option. It then sells the call option to the ﬁrm for a little more. But would the Wall Street ﬁrm now not be exposed to changes in the oil price? Yes—but it would hedge this risk away. In our example, the Wall Street Firm would undertake a (usually dynamic) hedge. That is, it would ﬁrst determine its hedge ratio, i.e., by how much the value of a synthetic 10-year call option with a strike price of $50 per barrel changes with the underlying oil price today. This value may be 0.08. In this case, the Wall Street ﬁrm would purchase a contract for 10, 000 · 0.08 = 800 barrels of oil. If the price of oil increases, then the Wall Street ﬁrm’s own position in oil increases by the same amount as its obligation to the gas station company. This way, the Wall Street ﬁrm has no exposure to changes in the underlying oil price.

Corporate Hedging

admin — Sat, 19 Sep 2009 07:26:01 +0000

Sometimes, corporations or individuals want to avoid exposure to changes in the value of certain assets. For example, an American corporation may have sold some product to a German corporation for payment in Euros in six months. But the U.S. corporation may prefer to lock in the value of the Euro payment to be received in order to avoid the uncertainties of the exchange rate. After all, it needs to purchase its inputs in U.S. dollars today.
This can be done by hedging the exchange rate risk. The idea is to purchase a ﬁnancial security that goes up by $1 in value if the product payment in Euros goes down by $1 in value (and vice-versa). For example, if there is a call option that increases in value by $0.33 if the Euro increases in value by $1, then the ﬁrm needs to sell three of these call options to neutralize its exposure. If the Euro goes up by $1, then the underlying contract payments will go up by $1 and the three call options will go down by $0.33 · 3. Conversely, if the Euro goes down by $1, then the underlying contract payments will go down by $1 and the three call options will go up by $0.33 · 3. Corporate hedging of uncertainties has become very common. The idea behind hedging is closely related to the idea of derivative securities: that is, a hedge ratio determines how many ﬁnancial securities are required to neutralize the effect of changes in the value of an underlying asset.

More Complex Option Strategies

admin — Fri, 11 Sep 2009 07:25:55 +0000

Multiple options are so often combined together that certain strategies have earned their own nicknames. If nothing else, discussing these positions gives you good exercises for graphing more complex payoff diagrams! The two basic kinds are spreads, which consist of long and short options of the same type (call or put), and combinations, which consist of options of different types.
Simple Spread A position that is long one option and short another option, on the same stock. The options are of the same type (puts or calls), have the same expiration date, but different strike prices. For example, a simple spread may purchase one put with a strike price of $90 and sell one put with a strike price of $70. You should conﬁrm that it is correct by constructing your own payoff table. Complex Spread (e.g., Butterﬂy Spread) Like a simple spread, but with more than one option. (You will get to graph the payoff diagram in one of the questions below.) Straddle A straddle is the most popular combination. It combines one put and one call. (You will get to graph the payoff diagram in one of the questions below.)
A calendar spread is a position that is long one option and short another option, on the same stock. The options are of the same type (puts or calls), have the same strike prices, but different expiration dates. Therefore, they do not lend themselves to graphing in payoff diagrams, which hold the expiration date constant.

Option Payoffs at Expiration

admin — Thu, 03 Sep 2009 07:23:03 +0000

It is easiest to understand an option via its payoff table and payoff diagram. You have already seen these in the house and capital structure contexts. A payoff diagram shows the value of the option as a function of the underlying base asset on its ﬁnal moment just before expiration. The characteristic of any option’s payoff is the kink at the strike price: for the call, the value is zero below the strike price, and a 45 degree line above the strike price. For the put, the value is zero above the strike price, and a 45 degree line below the strike price.

Splits and Dividends for Stock Options

admin — Wed, 26 Aug 2009 07:21:52 +0000

What happens to the value of a common stock option when the underlying stock pays a dividend or executes a stock split? In a stock split, a company decides to change the meaning, but not the value, of its shares. For example, an owner who held 1,000 shares at $80.50/share would in a 2-for-1 split own 2,000 shares. Splitting does not create shareholder value out of nothing—it should not change the market capitalization of the underlying company. Therefore, the resulting shares should be worth $40.25/share post-split.
Although such a split should make little difference to the owners of the shares ($80,500 worth of shares, no matter what), it could be bad news for the owner of a call option. After all, a call with a strike price of $75 would have been in-the-money (i.e., the underlying share price of $80.50 was above the strike price) before the split. If the option were American, the call would be worth at least $5.50 per share if exercised immediately. After the split, however, the call would be far out-of-the-money (i.e., the underlying share price of $40.25 would be below the strike price of $75). Fortunately, the option contracts that are traded on most exchanges (e.g., the CBOE) automatically adjust for stock splits, so that the value of the option does not change when a stock split occurs: in this case, the option’s effective strike price would automatically halve from $75 to $37.50 and the number of calls would automatically double from 1 to 2.
(Completing our option terminology, not surprisingly, at-the-money means that the share price and the strike price are about equal.)
But common options are typically not adjusted for dividend payments: if the $80.50 IBM share were to pay out $40 in dividends, unless money were to fall from heaven, the post-dividend share price value would have to drop to around $40.50. Therefore, the in-the-money call option would become an out-of-the-money call. Consequently, if your call was American, you might decide to exercise your call with a $75 strike price to net $5.50 just before the dividend date. In sum, when you purchase/value a typical stock option, you can ignore stock splits but not dividend payments of the underlying security.
Three ﬁnal institutional details. First, because the value of options can be very small, e.g., 72.5 cents for each IBM call option, they are usually traded in bundles of 100. This is called an option contract. Five option contracts on IBM are therefore 500 options (options on 500 shares), which in the example would cost $0.725 · 500 = $362.50. Second, CBOE options typically expire on the third Friday of each month, which is where the 20th of the month came from. Third, option prices that you read in the newspaper can be deceptive, because they are typically closing prices. However, the CBOE usually closes at 4:00pm CST/5:00 EST, which is half an hour later than the NYSE (4:30pm EST). This sometimes leads to seeming arbitrages in the newspaper, which are however non-existent because what really has happened is that the underlying stock price has changed. (In addition, newspapers may quote either recent bid or recent ask prices, rather than the price at which one can actually transact.)