The Marginal Revolution Podcast–Options!

Today on the MR Podcast Tyler and I talk about The Quest to Price Options. First, we run through the amazing history of option pricing theory from Bachelier to Black, Scholes and Merton with stops in between for Einstein, Samuelson, Thorpe and Kassouf.

We then look at how understanding options changes how one sees the world. Here’s one bit:

TABARROK: In the Hayekian-Mises business cycle theory, the interest rate is really the key thing. Everyone’s just following the interest rate. Interest rate falls because of government increases supply of money or something like that and everyone just goes into investment.

COWEN: Yes. It was Black himself who said, “No, it’s changes in the risk premium that are doing the work.” That was what he was working on before he died. The papers of mine he wanted to see, were actually on the same idea. The changes in the risk premium might be driving investment. How do we think about those in a business cycle context?

TABARROK: Yes. Those seem to be much more important than the pure interest rate itself. There’s a lot of investment decisions that you can think about like an option. Suppose you have a 10-year mineral lease, which gives you the right to drill an oil well anytime in the next 10 years. Well, when should you drill? It seems obvious that the higher the price of oil, the greater should be your incentive to drill. The price of oil goes up and down. You don’t want to drill the well and then find out that oil prices have dropped below the cost of extraction.

Once the well has been drilled, the costs are sunk, literally in this case. You can think about the decision to drill the oil well as exercising the option to drill. You want to use some model to figure out when, given the volatility of oil prices, is the optimal time to drill the well.

COWEN: It’s related to seeing all these underdeveloped or undeveloped storefronts in American cities. Oh, there’s something that used to be a store. Now, it’s all boarded up. Why don’t they put something in there? Why doesn’t the price adjust? Sometimes it’s regulation, legal issues, but sometimes it’s option value.

You’re not sure what you’re going to put in. You don’t want to have to remodel the thing again. Maybe it should be a restaurant, but your town is not yet ready for a Brazilian churrascaria and, in the meantime, everyone’s waiting.

….It’s a major problem in economicdevelopment. The Danish government is relatively credible. Many, but not all, parts of the US government are. That enables investment and growth. There’s plenty of countries, if you just look at the books, a lot of their laws don’t sound that much worse, say, than US laws. They might even sound better but no one knows what the law will be two, three, 10 years from now. It’s just harder for them to mobilize the proper incentives.

This is our last podcast of the year. What topics should we take on next year?

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