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.
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
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 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
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
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