Let me tell you how I invented the $7 bill. Most people think legal tender has to come from a printing press down at the Treasury Department, and that's true to a point, but then one day I thought what the world really needed was a good $7 bill. So I invented one by stapling together a five and two ones. My patent application actually covers everything from the $6 to the $9 bill, but I'm leaving the $11 bill and above for someone else: I am not greedy. What I've just invented is both a financial instrument and a derivative security (since it is derived from two other securities), though mine is the only derivative to my knowledge that can be used to buy a six-pack. Of course, I am not the only inventor of financial instruments. Another is Vergil Daughtery of Lake Junaluska, N.C. Vergil, a Georgia Tech grad and former paratrooper who until recently made his living setting up nonprofit group homes for disabled people, invented a financial instrument called the Expirationless American Option, or XPO, which just might make him a billionaire.
Financial instruments take many forms. "I'll gladly pay you Tuesday for a hamburger today" is one. So are savings bonds and lottery tickets. One amazing aspect of financial instruments is that you can invent one, own it, trademark it, and even get a patent on it. Anyone who wants to trade that instrument has to pay the owner a royalty. If you buy or sell options on the Standard & Poor's 500 stock index, for example, about 10¢ per trade (the precise amount is a big secret) goes to McGraw-Hill, owner of the Standard & Poor's trademark. Want to trade options on the Dow Jones Industrial Average? That will require a small per-trade payment to the publisher of The Wall Street Journal, thank you. Multiply that payment by the more than 1.5 million DJIA options and futures contracts sold at just the Chicago Board of Trade in just the month of September 2003 and you can see that owning a financial instrument can produce significant revenue.
But only if people trade it. If nobody plays, there is no payment, which is the risk accepted by the inventor and the exchanges that decide to be the first to list the instrument. That's where Vergil Daughtery stands today after 12 years and three patents, with his financial instrument closing in on approval for trading, by the middle of next year, on the proposed all-electronic NexTrade Futures Exchange, followed, if all goes as Vergil hopes, by other exchanges in the U.S. and abroad. (NexTrade, which was the first ECN approved by the Securities and Exchange Commission, is used to pioneering and battling the financial establishment.) If the traders come, Vergil will be the richest man on Lake Junaluska. If they don't--well, that's another story.
The purpose of this column is twofold. First, here's Vergil and his associates at Economic Inventions LLC maybe showing us a whole new way to work hard, take a few financial risks, and become incredibly rich in the process. The second purpose is to take a look at something interesting--interesting enough that maybe it will be of use one day to you or your business.
As Vergil has conceived it, an XPO is just a right (but not the obligation) to buy or sell some security (such as a stock or a future) or commodity (such as a currency or oil) at a certain strike price. The innovation here is that the right doesn't expire. There have been academic papers about "perpetual options," but nobody before Vergil seems to have thought to give it a try in the real world. So-called European options grant the right to buy or sell on the last day of the option period, while American options grant the right to buy or sell at any time between now and the end of the option period. The Expirationless American Option is a further extension--an option to buy or sell any time between now and the end of creation. Simple? No.
First there is the little problem that according to the early work of Fischer Black and Myron Scholes (the twin gods of derivative securities), XPOs ought not to function at all as a financial instrument. Not to get too technical, but the Black-Scholes option pricing model is based in part on the idea that the longer the term of an option, the more that option should be worth--with the upper limit equal to the underlying security. A perpetual option to buy a stock is no different than just buying the stock, according to this argument, so why bother with XPOs--especially since stock ownership confers added benefits like dividends and voting rights?
Vergil and his associate David Gleeson punch a big hole in the Black-Scholes argument. They cite what they call the Zero-Cost Takeover Paradox. "If you or I could sell XPO calls [options to buy] on a non-dividend-paying stock for an amount equal to the stock price, then we could do so repeatedly and use the proceeds to immediately purchase the stock itself until we gained control or complete ownership of the company," says Gleeson, whose title at Economic Inventions is president. "At such time we would gain voting control of the company and, ironically, the full ability to declare a dividend on all those shares we had purchased with the proceeds of XPO sales."
Since you could sell as many XPO calls as you like, you could start with a single share and eventually take control of General Motors. Well, that's absurd, meaning that the underlying assumption of Black-Scholes maybe isn't so sturdy. That doesn't mean Black-Scholes isn't useful, but it isn't reason enough to prevent the development of an XPO market. According to Vergil, the value of an XPO will peak, at different values for different strike prices, long before it reaches the value of the underlying asset, for reasons having to do with arbitrage, taxation, and the ability of investors to monetize concentrated investments.
And that takes care of that, right? Of course not. There are some serious doubters. "I don't believe there will be any meaningful trading in these options beyond some short initial period," says David Weinberger, who runs a large trading operation for a major financial institution in Chicago.
Time will tell. And Vergil may be a self-made man from Lake Junaluska, but he's not alone in this. An investor in his company is Steven M. H. Wallman, a former SEC commissioner in the Clinton years. Says Wallman: "Expirationless options are elegant in their simplicity, obvious in their utility, and beneficial for a wide variety of uses. It's great to have the chance to assist a new enterprise creating such a novel product."
Assuming that these arguments over how many economists can dance on the head of a pin will be resolved, the appeal of XPOs lies in how they can help manage financial risk.
Here's how an XPO compares with a future, for example. A futures contract can be used to limit risk, but it also limits profits. When you enter into a futures contract to sell a commodity such as oil at a certain price, you give up the opportunity to gain if oil prices rise more than you expected. With an XPO, as with all options, if prices move against you, you have the right but not the obligation to complete the contract. You can't lose more than what you've spent on the option, and your potential profit has no upper boundary.
Let's say you are General Mills and are concerned about what will happen to your costs if the price of next winter's wheat spikes up unexpectedly. You might guard against this outcome by purchasing futures contracts that guarantee delivery of wheat at a price that seems reasonable right now. If the winter harvest is unexpectedly bountiful and prices fall, however, you still have to take delivery at the contract price or, if they are still worth anything at all, sell your contracts to someone else.
If you had purchased an XPO, however, you would still have something worth owning. Because an XPO does not expire, you could hang on to the contract and use it again next year for the same purpose. Sooner or later, it's likely that a bad harvest will occur and wheat prices will spike. That explains why you might want to own an XPO call. Two reasons you might want to own an XPO put (which allows you to sell an asset) are liquidity and a tax advantage.
Say Cisco Systems stock is now trading at $20 and you are sitting on a lot of shares that you bought at $40. You could sell an XPO call that gives someone the right to buy your Cisco shares at $40, $60, or any price you decide to set as the strike price. Such a contract would be difficult to arrange if the option had to be exercised in 3, 6, 9, or 12 months, but what are the chances that Cisco will ever get back to $40 or $60 per share? Pretty good. So someone will probably take you up on your offer. And that's why Vergil believes that XPO buyers are likely to be easier to find than buyers of traditional options.
With XPOs, you'll also be able to sell, simultaneously, Cisco puts and calls. So no matter which direction the price heads, you're covered. In the meantime you've taken some money out of shares that were worth less than you originally paid for them without really touching the underlying stock or its voting or dividend rights. And if Vergil is successful in his ongoing negotiations with the IRS, then under IRS rule 1233b, the transaction won't be taxable until the position is closed by someone actually exercising the option.
This means that the XPO proceeds could be a tax-free, interest-free loan. XPOs won't let you avoid tax, but they will give you a lot more control over when a tax obligation is considered due and will even generate income from stocks that don't pay a dividend. Say you or your company is sitting on a pile of moldy tech stocks. Rather than sell shares, possibly at a loss, you sell XPOs on those non-income-producing shares, then use the proceeds to buy T-bills. And it's possible that IRS rule 1233b will allow that T-bill purchase to be seen as an integral part of the financial instrument, which means that at least for a while those "dividends" go untaxed. If the XPOs you sold were on the shares of your own company, the money goes untaxed forever. Heck of a deal.
I first wrote about XPOs two years ago, when Vergil was a lot further than he is now from getting his homemade derivatives listed. He thinks he's going to get his shot, and if he does, then the pricing questions and any other points of contention will be answered in the marketplace. It's likely that XPOs will initially trade on equities that have high liquidity, like large-company stocks (as in the Cisco example above), sector funds, and indexes. XPOs on futures will start with currencies (the yen, dollar, and euro) and U.S. Treasurys and will expand to cover other futures products.
"Some sort of XPO could be part of an optimal corporate finance solution," says William Margrabe, a derivatives consultant in Pelham Manor, N.Y., who has worked at Salomon Brothers Morgan Stanley and Bankers Trust, and who was Fischer Black's research and teaching assistant at the University of Chicago. "Other parts of that solution could include ordinary European and American calls and puts, ordinary debt, high-yield debt, and perhaps convertible shares and bonds."
The whole financial engineering industry is today a market with a notional value of approximately $1 quadrillion. Vergil and his backers own the rights to XPOs and stand to earn a small royalty on what could grow to be millions--even billions--of transactions per year.
Robert X. Cringely is a writer, broadcaster, and entrepreneur specializing in technology. Contact him at firstname.lastname@example.org.