On Friday I said good-bye to the consternatingly cold weather of Fontainebleau, and a fresh hello to the local liveliness that is Singapore.
Today we will talk about Financial Options, yet we won't talk about how poorly I did on the recent Finance Exam :). I found options fascinating because a) they help you evaluate and negotiate for the kind of stock options package you offer or are offered during the creation of a new company (especially in my Silicon Valley home turf) but more importantly for b) their real life applications outside of finance.
What is an option? Most clearly but least precisely, an option is a contract giving its owner the ability, but not the obligation (thus the "option") to buy a stock at a future time, where the stock's value at the future time is unknown (even though the stock's value is widely known at the time of purchase). If such a contract could be bought and sold, (informal markets can spring up around even the most restrictive of options contracts) you can imagine it would be tough to assign a fair price to it. So we spent a lot of effort learning how to value options contracts. But I suspect that only a few readers of this blog would actually care how such a contract is valued. Suffice to say that the more that an option contract's underlying stock value fluctuates, the more valuable the option.
Instead, I suspect that many readers do care about the value of projects they undertake. Look at going school to learn a new skill with uncertain longterm payoff, or traveling to a new locale to look for otherwise unknowable opportunities, or starting a new business with uncertain outlook. Are these activities worthwhile endeavours? Well it turns out that each of these activities is a form of real option, only mildly distinct from a stock option. Because of the high upside in being able to replicate and scale an otherwise small but value-producing project, and the low downside being the sunk cost of exploring the basecase of the opportunity, then these kinds of explorations in aggregate become very worthwhile.
I have to wonder then whether, over many eons, we've evolved the risk appetite required to explore options - i.e. in exploration of new food sources. However, while I would argue that such risk appetite is a superior trait for populations, it may be of net negative value for any particular individual singled out of a population. Because, while a roaring success may benefit that individual as well as the population around him, say, if (s)he found a new food source and also could control its public distribution for his/her benefit, it could also turn out that the exploration fails, and the individual perishes from exposure to whatever risky environment in which he placed himself in the first place. So, extrapolated over many generations of natural selection, this successively repeated scenario would breed individuals into risky-options-seeking automatons, who don't necessarily do so on the net likelihood of their own benefit. In a large population of such risky-options-seekers, some would inevitably succeed, improving the lot of the population, but those that failed would be crossed off the natural selection list, even though the same traits were being exercised in survivors and non-survivors alike.
So when it comes to the value of risky-options on the individual basis, I would argue that the jury's still out, and that economic conservatism may be the individual's value maximizing choice after all . . .
Coming up, look for discussion of the Singapore MBA student lifestyle.
