Jamesian Philosophy Refreshed

Occidental Petroleum has a fascinating corporate history. It is not at the top rank of oil companies -- it is for example now only the 9th largest petroleum producer in Texas. But it once served as the corporate vessel of the late Armand Hammer and it has seen more than its share of drama. Hammer ran the company from 1957 until his death in 1990. The latest drama with regard to Oxy happens to involve a contemporary businessman who is nearly as notorious as was Hammer in his prime: Warren Buffett, via Buffett's corporate vessel, Berkshire Hathaway. Until the coronavirus started freezing everything up, Occidental was in the midst of the acquisition of a smaller petroleum company, Anadarko. Berkshire was financing that transaction. As part of this deal, Berkshire received a lot of warrants (in effect stock options -- there is a distinction between warrants and options but not one pertinent just now).  So, Berkshire receive these stock options, yet they are nearly worthless as...

  We have travelled a long way. A look back is a good way to end a journey. We began with a discussion of some of the concepts essential to any discussion of contemporary finance. Why do stock prices move? Do they move randomly? We discussed the fact that modern finance theory has long used the bell curve as a randomness base line. Related to this, we said that the efficiency of markets, built as it is upon their liquidity and transparency, as well as the fact that a lot of very smart people are looking for an edge in competition with one another, is an adequate explanation for random movements, but that inefficiencies of inefficiencies of markets, which show up as skewed or otherwise non-normal curves, require other explanations. From there we moved to the questions: how stock options derive their value? And, what are the defining facts about bonds, either corporate or sovereign? We also discussed accounting, and so the balance-sheet difference between stock...

The above graph is a visual representation of the Black-Scholes model. Or Black-Scholes- Merton if you want credit shared equitably and "you're not into the whole brevity thing," Mr Lebowski. As you can see, there are three axes. The x axis (the width of the box) is the price of the underlying asset, the stock price, treating the strike price in the center as 1. The y axis (the height of the box) is the volatility of that option. The z axis (the depth of the box) is the time to maturity [and either exercise or expiration].   As you can see, the plane of various shades of blue (the darker the blue, the higher) has a sharp crease at the front/center/bottom of the box, where the sharp difference between winners and losers on the lottery’s drawing date is indicated. We should also mention that the volatility that goes into the calculations as we’ve described them above is historical volatility. One of the assumptions of the BSM model is constant volatilit...

  You’ll remember that in earlier posts I've discussed a hypothetical widget-making company, XYZ, and said that we could enter various reasonable assumptions about this company’s stock in a calculator available in any of several websites, and receive for our troubles the value of a proposed put or call. How does the calculator do that?   A skeptic may sneer at the whole idea and say, “only supply and demand determine the value of a financial instrument. The demand for an option on a particular stock may change from day to day – as may the supply, as new writers enter or leave the market – so surely no formula or algorithm can tell us in advance what the value is.” That’s a plausible response, but it is in error. The value of stock options can be defined mathematically in ways that the value of the underlying stocks cannot. After all, we know intuitively what the value of a stock option is on the expiration date. If it has expired worthless, we know the value i...

We'll resume our discussion of stock options from where we were here. The above photographed felon will come into our discussion soon enough. Options can be part of broader strategies that limit exposure in either direction. You can combine puts and calls to create a “collar” around the market price of the underlying stock, limiting both your own profit and your own risk. The word “straddle” has connotations similar to “collar,” suggesting that options allow the straddler to be on both sides of the same underlying asset at the same time. Yet “straddle” has a more aggressive sound to it. As it happens, Bernie Madoff used to tell prospective clients that he was following an options-based straddle strategy.   Of course, he wasn’t following any strategy, but he needed to sell a story, and that was it.   Such a straddle strategy, by the way, can work when carried out legitimately. It can do roughly what Madoff claimed that he was using it to do – produce a slow-but-...

I was thinking of writing here something about the now-concluded college basketball season. But since Great Britain's former Prime Minister Margaret Thatcher passed away recently I've changed my mind. I think the best tribute I can do Thatcher is to continue my recent discussions of some considerations pertaining to market economies. I'm told that was something of an interest of hers. Besides, I didn't have anything especially incisive to say about basketball. Today's question, then: First: what IS a stock option? It is either an option to buy (call) a stock or an option to sell (put) a stock. An option to buy a stock is a contract by which the buyer acquires the right (without incurring any obligation) to purchase shares of a stock at a specific price on a specified date.   An option to sell is much the same, except as you might already have inferred, the buyer of an option to sell acquires the right (again, without obligation) to sell shares of a...