All entrepreneurs have a dream. Vergil Daughtery's is to strike it rich with a novel financial instrument he calls XPOs (that's expirationless options, to you).
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.
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