Passport Options, Managed Fund Options, and Real Options

ART is currently investigating investment strategy analysis including the use of Passport Options, Managed Funds Options, and Real Options.  These instruments provide great flexibility and desirable characteristics for a range of investment considerations.  However, they each also share certain features that makes them difficult to value and risk manage, thus compelling market makers to "charge for the worst case".  Even this approach may be tenuous if the definition of "worst case" is inconsistent with market events.  As such, comprehensive analyses of such instruments, for both pricing/risk and investment decisions, may be best served by including simulation of the entire investment or hedging process. 

Passport Options

The basic idea is that the market maker sells the investor an "option on a P&L" that results from (a yet unknown) investment strategy that the investor would otherwise have followed.  The payout is the greater of zero or the P&L at the end of the investment strategy.  The investor does not actually execute any trades (save for the purchase of the Passport), but rather "phones in" the trades the investor would have done.  The market maker does not (necessarily) know in advance what (if any) trades the investor will "phone in".  From the investor's perspective this seems like a good deal since they need not execute any trades (and thus no costs, balance sheets etc), and they get whatever profits they would have made or zero.  

Of course there is also the cost of the Passport.  The market maker will tend to charge a high price for such an option since the cost of buying "upside P&L only" (rather like with Lookback options) is not cheap.  But worse, the market maker also faces a greater degree of uncertainty in their position keeping costs since they will then need to "react" to whatever "phone-ins" occur.

Managed Fund Options

To some extent Options on Managed Funds share similarities with Passport options in that the valuation of the payout will be dependent on the (yet unknown) rotation of investments in the fund over the life of the option.   Here again the dilemma for the investor is the consideration of an otherwise attractive and convenient structure weighed against the cost of the option.  In a similar manner, the market maker faces the additional dilemma of reacting to (yet unknown) transactions, and worse the time delay in covering rotation of fund components can be substantial (e.g. weeks) leading to the possibility of very great mismatches between the actions of the fund manager and that of the market maker.

Real Options

Real Options arise in the context of project finance and to a broader extent the "flexibility" that a process offers to changes in the management of the process.  As options have value due to flexibility (asymmetry), then also flexibility has an option value.  There has been considerable increase of interest in Real Options over last few years due to the IT (and TMT) sector activity.  Real Options have characteristics in common with Passport and Managed Funds Options in that their value will be dependent on the yet unknown stream of actions undertaken by the managers of a firm or project.  Thus the (synthetic) replications problems are similar, as are the difficulties with assessing a sensible "drift" term for any stochastic modelling.

What to do?

There a variety of approaches to dealing with these types of options.   The analyses of such instruments is considered with the following methodologies listed in order of increasing sophistication (and not surprisingly, in order of increasing cost of construction).

Use the standard Black-Scholes framework and "shoehorn" the problem to fit the solution.  Not really good enough to trade on, since ignores impact of strategy, forwards etc.

Still using a risk-neutral framework, embed a PDE solver (e.g. finite difference) into an optimiser that solves for the option price resulting from the best possible strategy.  This approach at least attempts to account for (some strategy) effects, but: 

- The risk-neutral arguments have some difficulties (and thus lead to inconsistent specification of forward drift)

- The underlying probabilistic assumptions (Gaussian root-2) can be grossly inconsistent with the market dynamics on which the "user strategy" is based. 

- The option price from this approach may well be the "most expensive" as this type of analyses tends to yield the option price for the case of the "best strategy" (as opposed to the market likely one, or the one the user implements), resulting with an option that may be "over priced" from an investment perspective.

- This approach does have the benefit that a "skilful/experience quant" as may be found in many investment banks these days, could construct a single factor version of such a calculator in as little as 1- to 2-man-months.

Probably the most comprehensive approach is to assess simulation of the user strategy against many market conditions, in a manner that also accounts for the holding period replication process, and all relevant issues (transactions cost, funding, liquidity, etc).  Moreover, back- and forward-testing such an investment strategy simulator against market real data would help correctly specify the pricing result.

If you are interested in obtaining research results on this issue please Request More Information and please feel free to indicate a few specifics of interest to you.

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