[Publications]

Beyond Puts and Calls: Option Pricing
as a Powerful Tool in Decision-making

by Glenn S. Daily

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:

This is just one application of option pricing theory. If you keep
your eyes open, you'll run across many others.


Glenn S. Daily is a fee-only insurance consultant in New York City.
He can be reached at www.glenndaily.com.

[Originally published in the March 1996 issue of The Actuary]

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