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The object of this book is to use option theory to illuminate the structure of legal rights. The project is a natural one. Law-and-economic analysis tends to absorb (with a lag) the most important discoveries of economics. And the advances in option theory certainly count as some of the most important and pragmatic developments in economic thought in the last twenty-eight years. The Nobel prize awarded in 1997 to Myron Scholes and Robert Merton was richly deserved and suggests the impact of option theory on the field of economics. But the option theory developed in and since the 1970s has had a tremendous impact on the nonacademic world as well. The Black-Scholes formula for pricing options quickly traveled from the pages of academic journals to the floors of the option exchanges. It is as close as economics has ever come to producing a formula with the authority of the equation E = [mc.sup.2]. Option theory has given rise to a host of new financial products both by identifying missing markets and by giving traders a powerful new way of pricing the new products. The trading of financial derivatives on option, futures, and swap exchanges has developed into massive markets.
The collapse of the hedge fund Long Term Capital Management (LTCM) suggests to many the failure of option theory to predict and control risk. After all, at its worst, LTCM was suffering losses of more than $100 million a day (on one occasion, $500 million). Just as Einstein's relativity theory gave us the H-bomb and nuclear reactor, Scholes's option theory gave us the financial equivalent of nuclear meltdown. For some, LTCM was the Jurassic Park of financial arrogance-teaching us that it's not nice to fool with Mother Nature. But I believe the real lesson is just the opposite. With $5 billion in equity, LTCM was able to borrow and invest over $150 billion. As with the Wright brothers, what is remarkable is not that this first attempt at flight crashed, but that it stayed aloft for so long. The ability to hedge huge risks has made dramatic headway. It's amazing that LTCM was able to manage a 30-to-1 leverage ratio (of debt to equity) for as long as they did. And the second generation of hedge funds are already back in business creating the kinds of stratospheric leverage that would have been hardly imaginable in the days before option theory.
Option theory has also enabled finance economists to discover options that are implicitly embedded in a wide variety of financial and nonfinancial phenomena. The analysis of "real" (nonfinancial) options is a burgeoning new field of scholarship. Seeing these options around us is not merely a redundant recharacterization of existing theories. If that were the case, there would be little payoff to learning the tools of option theory. But, as soon as one discovers a hidden option, it is immediately possible to use pricing theory to evaluate the implicit value of the option-by focusing on the five fundamental determinants of option value (value of the underlying asset, time to maturity, interest rate, exercise price, and volatility of the underlying asset).
For example, option theory lets us reinterpret shareholders in a firm that has issued debt as having a call option to buy back the underlying assets of the firm from the debtholders (by paying the debtholders the amount of the debt due on the date of maturity). When the debt comes due, if the underlying assets are worth less than the outstanding debt, the shareholders will choose not to exercise their call option (and the assets will belong to the debtholders in bankruptcy). If the underlying assets are worth more than the outstanding debt as it comes due, the shareholders will exercise their call option by paying off the debt, effectively buying back the underlying assets of the firm. Option theory thus makes clear why shares in a firm with $100 million in debt due in one year and only $90 million in underlying assets might still trade at a positive value (because the option to buy back the underlying assets for $100 million after a year is valuable even though the option is currently "out of the money"). It also illuminates why firms near bankruptcy have incentives to engage in risky behavior.
Seeing stock (in a firm with debt) as a call option on the underlying assets of a corporation is a neat example. But in some sense, option theory doesn't add much to what we already knew. Most students would already intuit that stockholders have a higher tolerance for risk than debtholders. And some would not be surprised that a firm that is technically insolvent could still have stock trading at a positive price. In contrast, the burden of this book is to show that the lens of option theory can produce counterintuitive and surprising intuitions. In fact, this chapter will later highlight six payoffs that are hard to see outside the option frame.
One of the most important contributions of option theory to our understanding of asset value is that options become more valuable as the volatility in the underlying asset increases. Even though we normally think of risk-averse investors eschewing volatility, it turns out that volatility in the underlying asset unambiguously increases the value of the option itself. The call-option interpretation of shares in a leveraged firm thus suggests that shares will be more valuable if the firm's underlying assets are invested in riskier projects.
The analysis of "real" options is also revolutionizing the way businesses analyze investment opportunities. The first impact of corporate finance on MBAs and derivatively on corporate America was in the use of net present value (NPV) analysis. Instead of comparing the "internal rate of return" to some undertheorized "hurdle" rate, MBAs were endlessly taught that it is more appropriate to discount all cash flows to their present value and to invest in projects that had a positive net present value. The NPV revolution was a substantial improvement over the prior technology. The only problem was that it ignored the option values that are almost always embedded in real investments. Firms often have (i) the option of discontinuing an investment in midstream, (ii) the option of expanding the investment, or (iii) the sometimes valuable option of delaying the beginning of an investment. Even investments that have a negative net present value may be profitable if the option components are properly valued. And in choosing between two alternative investments, the one with the lower expected NPV may actually be superior if its option values are systematically superior. The current revolution (which is slowly percolating through to the MBA curriculum) is to modify the standard NPV approach to take account (and price the value) of these real options.
It should not be surprising that these powerful ideas might provide some useful analysis for legal issues as well. Legal scholars of corporate law have already been putting the theory to good use in analyzing issues of corporate governance and bankruptcy-for example, finding the real options component in convertible bonds.
But the law creates options in many other contexts as well. The Holmesian notion that a contractual promise is the duty to perform or pay damages can be reconceived as a promissor's option. Option theory can be used to price this breach option. The importance of option theory in private contracting is dramatically illustrated in recent litigation involving Rent-A-Center. Rent-A-Center (RAC) is one of several companies in the "rent-to-own" industry that rents appliances, furniture, and a variety of other chattel, predominately to the working poor, in contracts that allow the renter to gain ownership if she rents for a sufficiently long duration. The industry has been accused of implicitly charging excessively high interest in these agreements. But rent-to-own agreements are different than traditional consumer credit sales in that the consumer has more flexibility. In a traditional credit sale, the consumer makes an unconditional promise to pay back the amount lent-and failure to do so amounts to a breach of contract (which in turn may affect the consumer's credit history). In a rent-to-own agreement, by contrast, the consumer does not promise to pay until it owns the chattel, but may return the chattel at any point without breaching its agreement. From an option perspective, the rent-to-own contract is equivalent to a traditional credit sale but where the consumer also purchases a put option-the option at any time to sell the chattel back to RAC in return for its future payment obligations. An appreciation of options once again allows us not only to see the implicit option but also to price it. This is important, because to assess realistically whether RAC is charging excessive interest, it is necessary to price the implicit put that the consumers are purchasing (on credit) as well.
In Hohfeldian terms, every "privilege" is an option to do some act and every "power" is the option to change some legal relation. Indeed, the Bill of Rights might be aptly relabeled as the "Bill of Options." One has the right to speak (or not), the right to practice religion (or not), the right to trial (or not). Just as Hohfeldian analysis lets us disaggregate constituent parts of a particular regime, the option perspective allows us in context after context to disentangle option and nonoption components of particular entitlement regimes. This dissaggregation makes it possible not only to more clearly interrogate whether constituent parts of a particular bundle of rights are properly allocated, but also to "price" the constituent parts. Applying option theory to the Takings Clause naturally leads one to ask whether the government should have "givings" rights (via put options) as well as the more traditional takings call option. An option perspective also leads one to ask whether the federal government should have an eminent domain (call) option to take states' Eleventh Amendment rights. Even accepting that the states have newfound entitlements against federal legislation does not by itself tell us whether the feds should be able to take this entitlement and pay damages. Just as the feds can exercise an eminent domain power over state land, one might wonder whether they could take a state's policy power interest in protecting (or failing to protect) its female citizenry and pay the states damages. Option theory again lets us not only see this as a possibility, but might aid us in pricing such a takings option.
This book uses option theory to illuminate different ways that policymakers can protect legal entitlements. The notion of a "legal entitlement" is an expansive one, encompassing such diverse rights as the right to bodily security, the right to a pollution-free atmosphere, the right to build a house that blocks another's view, and the right to damage another's reputation by false accusation. More than thirty years ago Guido Calabresi and Douglas Melamed noticed that legal entitlements tend to be protected in two distinctly different ways. Property rules protect entitlements by deterring nonconsensual takings, while liability rules protect entitlements by compensating the entitlement holder if such takings do occur.
The crucial jumping-off point is to see that liability rules give potential takers a call option to take. A liability rule gives at least one party an option to take an entitlement nonconsensually and pay the entitlement owner some exercise price. Thus, if the right against pollution is protected by a liability rule, a polluter may pollute if she is willing to pay damages.
From this option perspective, the only difference between liability and property rules lies in the price of exercising the option-the damages to be paid for the nonconsensual taking. Property rules set the exercise price so high that no one is likely to exercise the option to take nonconsensually, while the lower exercise prices of liability rules presuppose that some people may take nonconsensually.
The option analysis deconstructs the original distinction between property rules and liability rules. Whereas Calabresi and Melamed assumed that property rules involve consensual agreements and liability rules involve nonconsensual takings, the options analysis shows that both property and liability rules involve options for nonconsensual taking. In other words, property rules are actually a special case of liability rules: property rules are liability rules with an exercise price so high that the option is (almost) never taken.
The next chapter more formally defines options and introduces the details of option theory, but for now it is sufficient to see that options are crucially defined by identifying (i) who has the option, (ii) whether the option is to buy (a call) or to sell (a put), and (iii) the price of exercising the option. While the very names-"puts" and "calls"-can be initially confusing (and therefore off-putting), I hope to show that an option interpretation both simplifies our understanding of how entitlements are structured and illuminates how entitlements should be structured. One way that option theory simplifies is by providing a single model or frame in which to assess both property and liability rules. From an option perspective, these rules can be viewed as lying on a single spectrum: property rules confront defendants with a high ("out-of-the-money") exercise price while liability rules confront defendants with a lower exercise price.
Conceptually, this book asks how a court might want to allocate entitlements among individuals when the court is imperfectly informed about how much the individuals value the entitlement. Many of the following pages analyze a seemingly straightforward math problem. Imagine that a court is trying to decide which of two disputants should control a particular entitlement. Each disputant knows her own value for the entitlement, but the court sees only an unbiased probability function of each disputant's value. The court, among other things, wants the entitlement controlled by the higher-valuing disputant.
How should the court structure the parties' legal entitlements? A first intuition is that the court should simply give the entitlement to the individual with the higher expected value. This "mean" allocation rule would make a great deal of sense if the court were merely choosing among property rules; but we will see-through the lens of option theory-that giving the initial entitlement to the disputant who is, on average, lower-valuing can at times produce higher allocative efficiency. This result is, of course, counterintuitive. But, as we shall see, so are others.
Excerpted from OPTIONAL LAW by IAN AYRES Copyright © 2005 by The University of Chicago. Excerpted by permission.
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