Options: The value of an Investment Vehicle

We are in the midst of a revolution in the world of financial derivatives, and questions abound. What is the value of an option? Should an investor buy r write them? What is the logic behind investing or financing with options? What strategies should be used with derivatives? This issue of Quants attempts to address these questions. Carried on an unprecedented wave of innovation, derivatives have rewritten the rules for investing and hedging * not without a number of mishaps that have tarnished their reputation. The use of derivates, like any hi-tech products, requires properly trained practitioners equipped with the appropriate information systems. However, products or combinations of products have often been sold with little thought for the buyers‘ motives or consequences of their use. For readers less familiar with valuing derivatives, we review the theory of arbitrage, which provides a theoretically risk-free method of fabricating options. This corresponds to managing a portfolio with variable composition whose cost is the price of the option. The investment value of the option, depends on the requirements of the investor as well as on his expectations and his wealth or net worth. If the value is equivalent to the discounted future return, it can be analysed as the deviation between that return and the premium. In theory, the value of a call option on an equity is greater than its price. And while the results of our statistical work on the CAC 40 and its component stocks confirm this analysis, they nevertheless show that returns are highly dispersed. Turning to the selection of options for investment purposes, we demonstrate, for several types of criteria, that the acquisition of derivatives is always profitable if one excludes the traditional mean-variance approach. In particular, we describe an approach based on the microeconomic theory of utility, which we illustrate by applying it to the investment of a company director who holds stock options.