XPO Theory to Get Real-World Test
By Christopher Faille, Reporter
Thursday, June 30, 2005 2:02:09 PM ET
PHILADELPHIA (HedgeWorld.com)—A man who at one time aspired to a Ph.D. in finance, then abandoned the academic track because his thesis idea was too sharp a break from established theory, will soon see that theory tested by the marketplace.
Daniel Carrigan, vice-president, new product development, Philadelphia Stock Exchange, confirmed Thursday that the PHLX plans to launch expirationless options. The XPOs will begin trading this year on Standard & Poor's Depositary Receipts (SPY). The exchange is targeting a launch in the fall.
PHLX has signed an agreement to this effect with NexTrade, an electronic trading platform. Since this would be a new class of derivatives, both of those parties are in talks with the Options Clearing Corp. on how to arrange for its clearing.
Vergil Daugherty, the chief executive of Economic Inventions LLC, which has licensed the exclusive patent rights to XPOs to NexTrade, said that the idea behind it occurred to him while he was a student of economics in the early 1990s. The Black-Scholes-Merton model of option pricing presumes that a perpetual European option has the same value as the underlying stock. Mr. Daugherty said that he understands why the founders of that famous model (Robert Merton in particular) employed this assumption—it's a mathematical shortcut.
But it has no real-world meaning. A European option, by definition, is an option that can only be exercised at its expiration. A perpetual European option, then, can never be exercised, which sounds valueless. Mr. Daugherty said in an interview that he saw this as a "big sucking wound of a logic error" in the heart of options theory. He abandoned his plans to pursue a Ph.D., because "it's hard to get a Ph.D. when your thesis statement is basically that there's a major error in the literature."
So he has set out to prove his ideas in the market.
In January 2004, NexTrade announced that it was in discussions with the Chicago Board of Trade Previous HedgeWorld Story to "potentially work toward developing new CBOT financial products" that would make use of Mr. Daugherty's patent.
Mr. Daugherty said he shifted the product's development from Chicago to Philadelphia because the latter seemed the more promising venue for the launch, but that "I've never heard anybody at the CBOT say anything negative about the idea."
A few negative words, though, have come from the National Bureau of Economic Research. In a recent working paper, "Innovation and Its Discontents," NBER scholars Adam B. Jaffe and Josh Lerner argue that "the role of patents in the U.S. innovation system has changed from fuel for the engine to sand in the gears." Vergil Daugherty's patent on an XPO is one of their examples of a dysfunction in the system, because the patent examiner overlooked prior art.
If an investment bank, or an "annoyed academic," had been in a position to send pertinent materials to the patent examiner, the article suggests, either might have sentsent "the 1960s-vintage papers on the subject by Paul Samuelson. While the articles themselves are somewhat technical, one only needs to read their abstracts to realize that an infinite-lived option is not a new idea."
Its worth noting that the Samuelson papers in question preceded the general acceptance of the Black-Scholes model, so one might infer that even if Messrs Jaffe and Lerner have a point about the prior art, Mr. Daugherty deserves credit for the rediscovery and promotion of the idea in the face of the adverse climate that Black-Scholes' success created. |
