Monday, August 2, 2010

Cash as the real real option -- to do anything

I came accross this posting following the hint of a friend. Since I have written very little about options todate, I thought this may be a good introduction to the topic. It is a piece written by Nick Row of Carleton University.

Option theory was originally about financial assets called options. A put option is a derivative that gives you the right to sell some asset at a pre-specified price. A call option is a derivative that gives you the right to buy some asset at a pre-specified price. They are called options because you have the right , but not the obligation , to sell (or buy). You don't have to exercise the option, if you don't want to. Option theory tries to figure out how much options were worth.

Then people noticed that this could also be a useful way to think about investment decisions in real assets (bricks and mortar etc.), not just financial assets (bits of paper). And "real option" theory was born. Any parent who has told his daughter to get a degree, just in case her career as a rock musician doesn't pan out, is advising her to invest in a real option. She isn't obliged to exercise her option to work as a teacher, but she can exercise it if she decides she wants to, when she has more information about her chances of making it big.

One of the neatest concepts in real option theory is the option value of doing nothing. Suppose you can earn an expected rate of return of 6% by insulating your house, and can borrow money at 5% to finance the investment. It sounds like a profitable investment, which you should undertake. Not so fast, says real option theory. Maybe you could earn an even higher expected return by waiting a year, and then deciding. You might find the cost of heating oil is higher. So you would want R30 instead of R20 insulation. Or maybe the cost of heating oil will be lower, and so you want R10 or don't want any insulation at all.

If you knew in advance what the future cost of insulation and heating oil would be, you could decide today whether to insulate or not, and how much to insulate, even if you decided to postpone the actual investment until next year. But if you can't predict the future, there's a benefit to postponing the decision until next year, when you will have more information on how much insulation (including none) would be the best investment. There's also a cost of postponing the decision of course, since you are losing the first year's profits on the investment.

Uncertainty is necessary for the option value of postponing the decision to be worth something. But it's not sufficient. If you never learn anything by waiting, you might as well decide to roll the dice now. And if what you choose to do isn't affected by what you learn (because you can only fit R20 into the attic and R20 is profitable for any conceivable price of heating oil) there's no value in waiting either. It's when you learn a lot just by waiting a short time, and what you do depends a lot on what you learn, that the option value of postponing a decision is highest.

And the investment decision has to be irreversible of course. If you could take the insulation out and get your money back, or add an extra R10 to your R20 at no extra cost compared to installing R30 originally, there's no point in waiting.

Real option theory sounds really neat. But there's something missing, or left out, or just assumed to be there in the background but otherwise ignored. It's cash.

It's not surprising really. As far as I know, most people doing real option theory are at Biz Schools, or are microeconomists. Not that there's anything wrong with that. But they are not monetary economists, so it's not their job to look at the other side of the coin.

You can't just do nothing; you must always be doing something, even if it's lying on the sofa staring into space. If you don't invest in real assets, what are you holding instead? What do you compare the returns of real investment to? What's the alternative? What's the opportunity cost?

You can't just do nothing with your income; you have to spend it on something. If all things you could spend it on were irreversible, then you can't talk about the option value of doing nothing, or postponing a decision. You have to decide now. You could insulate your house with R20, or buy a new car, or buy a holiday, but none of those expenditures is fully reversible. You can't return the holiday after you have enjoyed it; you can't re-sell the new car and get anything like what you paid for it.

There is one thing you can spend your income on that is very reversible: cash. In fact, if we spend our income on cash, we don't even think of that as spending it at all. We think of that as not spending it. We think of holding cash as doing nothing. In fact, since we live in a monetary exchange economy, our income comes to us as cash anyway. So it's not like we make a decision to invest in cash today, and then reverse that decision next year. We have the cash already, and can decide to spend it now, or decide later to spend it later. Holding cash keeps our options open. Cash is the real real option -- to do anything.

Talking about the option value of doing nothing only makes sense in a cash economy. If we invest in insulation we cannot reverse that decision next year. If we hold cash, we can reverse that decision next year. Holding cash is to hold the option. Holding insulation is to exercise that option, so you no longer hold the option.

Cash is the most liquid of all assets. We measure the liquidity of all other assets against cash. One measure of liquidity is the cost of a round-trip, from cash, into an asset, then back into cash. What percentage of our cash do we lose by making that round trip? And that definition of liquidity is just another way of measuring whether an investment is reversible or not.

Suppose we live at a time when uncertainty is high, but we expect a lot of that uncertainty to be resolved soon. Just by waiting a short while we should learn a lot. That is when the real option value of doing nothing should be highest. That is when the demand for real investment should be lowest. But, compared to what? Compared to cash of course. Doing nothing means holding cash. That is when the option value of holding cash should be highest.

I think we have been living in such a time, and are slowly coming out of it.

Lots of people, Keynesian fundamentalists especially, will say "Of course! Didn't Maynard say that uncertainty creates liquidity preference?" And they are partly right, but mostly wrong. It's not uncertainty, but uncertainty that you expect to be resolved quickly, that creates liquidity preference. You can't learn anything about the dice by waiting, so you might as well place your bets and roll them now, and learn whether you win or lose. It's not the level of uncertainty that matters for liquidity preference, but the expected rate of change of uncertainty.

Maybe that's why investment is always the last thing to recover after a financial crisis. It doesn't recover as uncertainty gets resolved. It recovers when uncertainty stops getting resolved. That's when there's no point in waiting and seeing any more. Until then, people and firms will want to hold cash.

God forbid they ever announce that reliable crystal balls will be cheaply available -- next year. That would cause an instant collapse of investment, and a recession. Every student would wait till next year before deciding what subject to take. All the professors would be unemployed.

Yep, I've been deliberately vague by what I mean by "cash". Sorry. Also, I confess I can't have spent more than 10 minutes of my life actually reading any real option theory. Sorry again. How much did it show?

Here is a link to Nick's blog.

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