Beyond Puts and Calls: Option Pricing as a Powerful Tool in Decision-making
Option pricing theory is a major accomplishment of modern finance. It spurred the development and widespread use of familiar financial options, such as puts and calls on common stocks, as well as exotic derivatives. More recently, theorists have turned their attention to the everyday financial decisions that individuals and businesses must make. Should you build a factory today, or wait to see what your competitors do? Should you default on your mortgage now, or wait to see if property values fall further? Should you be a leader or a follower in adopting new technology?
These decisions share three characteristics: (1) they are irreversible; (2) they can be postponed; and (3) their outcomes are uncertain. As Avinash K. Dixit and Robert S. Pindyck explain in Investment under Uncertainty (Princeton University Press, 1994), this combination places the analysis of investment opportunities in the province of option pricing theory.
When a financial decision is irreversible, making a commitment today kills the option to wait until tomorrow. This option to wait is worth something, so you should factor its loss into your decision. People implicitly recognize this when they talk about wanting to keep their options open. By providing tools to quantify the value of the option to wait, option pricing theory gives people a more realistic framework for making decisions.
The traditional rule taught in finance courses is that you should undertake an investment project if the net present value is positive. The new rule, derived from option pricing theory, is that you should invest today only if the net present value is high enough to compensate for giving up the value of the option to wait. Because the option to invest loses its value when the investment is irreversibly made, this loss is an opportunity cost of investing.
What does this have to do with buying and selling insurance? Consider lapse-supported life insurance products. There is a lively debate among actuaries about the merits of this pricing technique. Proponents argue that it rewards long-term policyholders, because of better persistency, better mortality (due to better persistency), and lower reserves and target surplus. That may be true, but lapse- supported pricing means low early cash values and that introduces irreversibility and the value of the option to wait.
To compensate the buyer for giving up the ability to reverse his decision and get his money back, a lapse-supported product must offer better long-term values than a low-load product with high early cash values. How much better? It may take years for researchers to answer this, but published estimates for other decisions suggest that an option-aware consumer would probably find a lapse-supported product unattractive.
Indeed, it might be hard to justify the purchase of any product with low early cash values. In an option pricing framework, "buy term and invest the difference" becomes "buy term while you wait for the right time to buy a cash value policy." Taking into account the value of the option to wait, is it ever the right time to buy a low-cash-value policy, or should you just keep renewing your term policy to age 100?
What can a company do to encourage purchase decisions? The short answer is that it must find ways to reduce the buyer's perceived risk of regret, and therefore the value of the option to wait. Here are some suggestions:
- Make financial strength a clearly-stated corporate goal. For example, announce that it is corporate policy to maintain financial strength ratings of AA or better from at least two rating agencies.
- Provide product enhancements to existing policyholders, even when a traditional cost analysis might say no.
- Levelize commissions, to permit higher early cash values.
This is just one application of option pricing theory. If you keep your eyes open, you'll run across many others.[Originally published in the March 1996 issue of The Actuary]