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.
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