The Concept of Opportunity Cost and the Functional Analysis of Financial Derivatives
The Concept of Opportunity Cost and the Functional Analysis of Financial Derivatives
In the economic concept we introduced, "opportunity cost" is deeply rooted in people's hearts. It is not only active in the academic circle of economic theory, but also highly valued in all aspects of real economic life, even extending to political system, legal concept, social management and many other aspects. For financial investment, stock and securities industries, "opportunity cost" is often used together with the concept of risk, which becomes the most important aspect of investment decision-making and risk judgment. Regardless of the "opportunity cost", most investors will be considered as "unqualified" investors.
Opportunity cost, also known as substitution cost, refers to the value that the production of one commodity takes up resources and cannot be used to produce another commodity under the condition of limited production resources. In other words, when a resource can only be used to produce a product, the value of the unselected product is the opportunity cost of the selected product. For example, if a batch of steel is used to produce machine tools, it cannot be used to produce cars, and the value produced by producing cars is the opportunity cost of producing machine tools; Similarly, when steel is used to produce cars, the value generated by producing machine tools is the opportunity cost of producing cars. Due to limited resources, producers can only make choices in different product production decisions. Choose one and discard two, and choose the right one, that is, the opportunity cost is low and the economic benefit is good; On the contrary, if the opportunity cost is high, the economic benefit is not good. Because opportunity cost is not the actual cost of producing products, it is more conceptual.
Undoubtedly, this is an economic concept with great practical value. When it is introduced into the investment field from the production field, the investment funds will be regarded as resources. In the choice of investment, if you choose one instead of another, there will be an "opportunity cost" of investment. Investors' investment decisions are all made after comparing and selecting investment projects in many aspects. Projects selected but ultimately not invested naturally become the main body of opportunity cost calculation. The opportunity cost of the selected investment is all the possible value gains of the investment subject plus the investment value.
When the concept of opportunity cost is introduced into the investment field, correspondingly, people's concept of risk has also changed greatly. In traditional investment activities, people usually only calculate the cost from the investment activity itself, such as investment consulting cost, investment feasibility study cost, investment production material cost, labor cost and so on. , constitute the actual cost of investment. An investment project or object, only the various expenditures spent on it belong to the scope of cost calculation. On this basis, the success of investment depends on the income generated after investment, and the level of investment cost depends on the income, which has nothing to do with projects outside the scope of investment activities. The investment risk under this concept of cost is the result that there may be no income after investment and the investment capital may be lost. With the concept of opportunity cost, investors will expand the scope of risk. If the investment project or object has benefited, but it has not reached the expected level, and it has not reached the income level that may be generated by investing in another project or object, that is to say, the income level realized by investment is not higher than the opportunity cost, which means that the investment is unsuccessful, the investment has not obtained the "opportunity" income, the investment decision is wrong, and the relevant investment decisions and activities are risky.
It is this concept of investment opportunity and investment risk that has revolutionized investors' consideration of investment. Investors no longer simply take the direct income of investment as the standard to judge whether the investment cost is or not, but analyze the relationship between income and risk and "opportunity cost", which greatly improves the requirements for investment success. Accordingly, people have introduced new risk analysis methods and a large number of tools and methods to avoid risks, trying to get the maximum benefit or reduce the risk to the minimum level in any investment activities. Financial derivatives are one of the important tools.
It should be said that the current financial derivatives are mainly a method and a tool for our world. This seems to indicate that all products related to financial activities cannot be "derived", such as interest rates, stock indexes, foreign exchange and debts. Therefore, we can't subdivide the types of financial derivatives at present. Futures, options, swaps and repurchases related to financial activities all belong to the category of financial derivatives. Therefore, financial derivatives can be defined as new investment objects designed on the basis of existing financial products. Obviously, as an investment object, the functions of financial derivatives are clear: first, the function of avoiding risks; Second, the speculative arbitrage function, investment has the possibility of speculation, financial derivatives are not general investment targets, and speculation is powerful. As far as the hedging function of financial derivatives is concerned, with the expansion of investors' risk concept, this function of financial derivatives seems to be more attractive and prominent.
Take the stock futures index as an example to discuss. As far as a single investment is concerned, stock investment may be one of the riskiest investments in the world, which leads to the requirement of investment hedging. Stock index futures are products that are "derived" from such requirements. For an investor who owns a variety of stocks, stock index futures is the most effective tool to avoid risks, and it runs in the opposite direction to the stock index futures market. After a certain period of time, the stock price really fell, the stock in the investor's hand depreciated, and his investment lost money; However, stock futures also fell. He hedged by buying stock futures and got a positive return in the futures market. As a result, investors didn't lose money, and maybe they could make some money. The most common situation is that he loses very little.
Similarly, if an investor shorts the stock after selling it, and the stock price goes up, it will be a loss for the investor. He needs other ways to make up for this loss, so he needs to buy stock futures to avoid this risk. If the stock market price rises, the greater the loss of his selling stocks; On the other hand, in the stock futures market, when the price of stock index futures rises, you can get considerable returns by selling contracts. In this way, after the positive and negative balance, at least the risk is reduced, and the hedging function of stock index futures is particularly sufficient.
In the opposite operation of the stock market and the stock index futures market, we can note that if investors do more in the stock market and do not use the hedging function of the futures market at the same time, then investors may have two results: first, the stock price rises, and stock investors sell stocks and get considerable investment income; Second, the stock price has fallen, and investors in the stock have to sell it because of problems such as capital turnover, which has caused great investment losses. Compared with being a long position in the stock market and a short position in the stock futures market at the same time, investors may gain a lot or suffer heavy losses, and the fluctuation curve of income is considerable; However, people who use the stock futures market fluctuate between losing money and making small profits, and the curve is flat.
Similarly, when investors short in the stock market, without using the stock futures market, investors may be happy to sell it in time because of the price drop, reducing losses or making profits; On the contrary, if the stock price rises, investors may regret selling the stock prematurely, causing huge losses. Different from the situation of using stock futures market, the income fluctuation curve of this kind of investment activities is peak and trough. If the stock futures market is used, the fluctuation curve of income is flat.
It can be seen that whether to use stock futures for reverse operation is actually an investor's choice of whether to make insurance for investment. If it is done, investors will no longer have a huge risk of investment loss, but at the same time, it will also make investors lose the possibility of obtaining greater returns. You can't have your cake and eat it. The risk is avoided, but the opportunity to make big money is also lost. We admit that this is indeed the hedging function of financial derivatives investment. However, if knowledge only stays here, our thoughts will be too narrow.
After careful analysis, we can find that using the stock futures market to avoid the risk of stock investment is essentially an idea of exaggerating the opportunity cost, and investors pay too much attention to the unrealistic cost of stock investment. In the case of being a multi-investor, he exaggerated the risk brought by the possible decline of the stock price, but did not want to sell the stock immediately, so he used stock futures products; As a short-selling investor, he exaggerated the risks brought by the possible rise of the stock price, but he had no choice but to short, so he used the products of stock futures. The bulls want to hold shares, but the bears don't want to invest immediately. They all regard the opposite operation as opportunity cost: bulls are afraid of losing more by selling stocks, and bears are afraid that buying immediately will be extremely uneconomical. As a result, the opportunity cost has become the most important consideration of investment, and at the same time it has been placed in an enlarged position, and investors are at a loss. Finally, simply using the stock futures market to "insure", the exaggerated opportunity cost immediately becomes a realistic risk measure, and investors use stock futures to eliminate risks and opportunities to increase returns.
But opportunity cost is not actual cost after all, and investment in stocks needs to consider opportunity cost. If you care too much, you will lose the meaning of investment itself. When making any investment, investment amount, actual cost, investment income and investment loss are four real indicators that need to be calculated. When a stock investor is long, he should fully study and understand the situation of the stock market. If he estimates that the stock price will fall, the simplest and most reliable response is to throw the stock in time; When a stock investor is short, if he estimates that the stock price will rise, he should buy in the stock market in time to make a profit. If the investor's estimate is wrong, the investor will have to pay the actual investment loss or actual cost. Using the stock futures market to "insure" the value is actually a way to keep the existing value in hand unchanged for a period of time, which has nothing to do with the analysis and judgment of stock investors on the market. No matter whether the market goes up or down, the value in the hands of investors remains basically unchanged. Is this an investment in a positive sense? In this regard, the function of maintaining the value of stock futures products is a negative tool, which makes investors have no risk of changing the investment value and no positive force to increase the investment value.
The problem goes far beyond this. Qian Qian, there are thousands of investors in the stock market. If every investor does this, no matter whether he is short or long, the risk of investment is "insured" by the operation of the stock futures market, then the value change of the stock market will be basically stable. On the whole, the modern stock market, whether developed or developing countries, has the nature of "zero-sum transaction" or quasi-"zero-sum transaction", that is, some people in the stock market make money, which is bound to be caused by some people losing money. After investors use stock futures to hedge their value, the stock market is bound to be extremely stable, and no one can make use of the fluctuation of the stock market to invest. In this way, the existence of the stock market is problematic. Without speculating in the stock market, what speculators are there? Is the average investor, who doesn't want to buy at a low price and sell at a high price? What is the necessity of the stock market?
Theoretically, if stock futures products are only used as hedging tools by investors in the stock market, the hedging function of such products is likely to send the stock market to the history museum. However, the actual operation shows that the stock market does not have survival problems because of the emergence of the stock futures market. On the contrary, it makes the stock market more active and volatile. This fully tells the world that the most important function of stock futures products is not to preserve value, but to speculate. Although stock futures products are produced from stock products, they are far more speculative than the stock itself, which is the most important conclusion we have drawn from the analysis.
Although there is no consistent conclusion on the function of financial derivatives at present, there are different opinions and controversies about them. From our analysis, we can see that the importance of financial derivatives lies not in its function of avoiding risks, but in its greater speculation. In fact, investors value the speculative function of financial derivatives such as stock futures, that is, their speculative way of "small and broad", and not many people really use financial derivatives to avoid risks and preserve value. This model should be an important basis for studying financial derivatives. Of course, this conclusion is of special significance to the policy-making and decision-making departments of financial derivatives management.
New development of investment decision theory--a review of real option theory.
The current investment decision theory came into being in the middle of the 20th century, and its maturity was marked by the publication of the book Capital Budget (Dean, 195 1). Subsequently, markowitz (1959) put forward the portfolio theory, and on this basis, Sharp (1964) and lintner (1965) put forward the capital asset pricing model (CAPM). Portfolio theory and CAPM established securities pricing based on risk and return, which was not only warmly welcomed by many investment institutions and investors, but also greatly changed the company's asset selection and investment strategy, and was widely used in the company's investment decision-making practice.
Today, the defects of the current investment decision-making theory are increasingly obvious. More and more theoretical and practical workers call for the revision of investment decision theory. Further research on investment decision theory has become the requirement of the times. In recent ten years, the development of investment decision theory is mainly reflected in the research of investment decision theory based on real options.
First, the origin and establishment of real option theory
Real option is an actual investment opportunity, which refers to the right with option nature existing in real assets. In other words, it is to apply the concept and method of options to physical assets, especially the company's capital budget evaluation and investment decision. Its theory originated from the dissatisfaction of practitioners, strategic experts and theoretical workers with the current investment decision-making theory.
Long before the emergence of real option theory, company managers and strategists intuitively realized the flexibility of management and the value of strategic role. Therefore, in reality, they do not simply apply the net present value method to make investment decisions. On the contrary, they often make decisions based on personal experience. Dean (195 1), Hayes and Abernathy (1980), Hayes and Gavin (1982) pointed out that the standard cash flow discount method often underestimates the value of investment opportunities, resulting in short-sighted investment behavior and insufficient investment. Decision theorists further improved the net present value method with decision tree method in 1960s, but this can only partially reflect the elastic value of investment decision. Myers (1977, 1987) pointed out that the traditional discounted cash flow method has its inherent defects in evaluating investment opportunities with operational flexibility and strategic functions. He believes that the cash flow generated by investment comes from the use of assets currently owned and the right to choose future investment opportunities. At the same time, he applied the concept of option to real assets and proposed that financial option pricing theory can be used to evaluate such investment opportunities. On the basis of Myers' view that some investment opportunities are "growth options", Kester (1984) discussed the strategy and competitive function of growth opportunities. Trigeorgis and Mason( 1987) pointed out that the evaluation method based on option pricing theory is a more appropriate method when evaluating the flexibility and strategic role of companies. Baldwin and Trigeorgis( 1993) pointed out that we can solve the problem of insufficient investment and rebuild our competitive advantage by purchasing and managing the company's real options. Mason and Merton( 1985), Trigeorgis( 1988), Brealey and Myers( 199 1) and Kulatilaka and Marcus( 1988,1). Among them, Mason and Merton( 1985) discussed many real options in investment and operation in detail, and gathered them together in the form of a hypothetical large-scale energy investment project.
Second, the theoretical basis of real option pricing
The theoretical basis of real option pricing comes from the pioneering work of Black and Scholes( 1973) and Merton( 1973) on financial option pricing. The discrete-time binomial pricing model proposed by Cox, Ross and Rubinstein( 1979) makes option pricing relatively simple. Margrabe( 1978) discusses the option pricing of two kinds of risky asset swaps. Stulz (1982) analyzed the option pricing of the maximum (minimum) value of two risky assets. Johnson( 1987) further extended the above analysis to option pricing of various risky assets. These studies make it possible to analyze the abandoned and converted real investment opportunities (real options). Gasca (1979) discussed the pricing of compound options, which can be used to evaluate the value of growth investment opportunities in theory. Karl (1988) comprehensively analyzed the pricing of series (compound) exchange options. The above work, at least in theory, can be used to price serial investment and other practical investment opportunities (real options).
Cox and Ross( 1976) pointed out that financial options can be regarded as a combination of specific tradable securities, that is, the concept of synthetic options was put forward, which made option pricing possible. The basic feature of risk-free pricing system is to construct equivalent tradable securities portfolio. Because it has nothing to do with risk attitude and capital market equilibrium, risk-neutral pricing discounts future expected returns at risk-free interest rate. Rubinstein (1976) also gave the standard Black-Scholes option pricing formula without continuous trading opportunities and risk aversion. Mason and Merton( 1985), Kasanen and Trigeorgis( 1994) pointed out that in theory, real options can be priced with a theory similar to financial options, because although real options cannot be traded, in investment decision-making, we are concerned about what the company's cash flow is if it can be traded. For real option pricing, the existence of tradable twin securities (or dynamic combination of tradable securities) with the same risk characteristics as non-tradable physical assets in the market is enough to solve the problem. The research of Garman( 1976), Constantinides( 1978), Harrison and Kreps( 1979) and Cox, Ingersoll and Ross( 1985) further shows whether contingent assets can be traded as long as they are priced. For real assets without systemic risk, the growth rate of equal certainty or risk neutrality is equal to the risk interest rate. However, if the underlying assets are non-tradable, its growth rate will be lower than the equilibrium expected rate of return of equal risk tradable financial securities. Because of the gap between the two, it is necessary to adjust dividends when pricing options. MacDonald and Siegel (1985) pointed out that the market equilibrium model can be used to estimate the differences between them.
Third, a summary of various real option pricing theories.
There are many literatures about real option pricing. Most of these research documents are aimed at a real option and generally give an analytical solution. MacDonald and Siegel (1986), paddock, Siegel and Smith (1988) and Tourinho (1979) all discussed deferred options. Ingersoll and Ross (1992) studied the influence of interest rate changes on investment value. Pindyck( 1988) studies the value of deferred options in a series of investments and analyzes the best investment progress. Carr( 1988) and Trigeorgis( 1993) also discussed a series of investments. Trigeorgis, Mason( 1987) and Pindyk (1988) studied the expansion and contraction options. MacDonald and Siegel (1985), Brennan and Schwartz (1985) analyzed the liquidation and reoperation options. Myers (1990) analyzed the waiver option. Margrabe( 1978), Kensinger( 1987), Kulatilaka( 1988), Kulatilaka and Trigeorgris( 1994) have studied the conversion options. Myers( 1977), Brealey and Myers( 199 1), Kester( 1984, 1993), Trigeorgis and Mason( 1987).
Although these studies enrich the pricing theory of real options, they are not of great practical value because they are mainly aimed at pricing specific types of real options in a specific period. In reality, investment projects are generally very complicated. Usually, an investment contains a variety of real options, and the values of these options affect each other. The only exception is the study by Brennan and Schwartz (1985). In the study, they analyzed the comprehensive value of the real options that were suspended (restarted) and abandoned. They pointed out that changing the partial irreversibility of mine operation state will produce an inertia or lag effect, which makes it relatively beneficial to maintain a stable operation state for a long time. Although lagging utility is a form of the influence of early decision-making on later decision-making, they have not explicitly studied the interaction between different real options.
Trigeorgis( 1993) analyzes the interactive characteristics of real options, and points out that the existence of subsequent real options can increase the value of early real options to the underlying assets, because the implementation of early real options will change the value of the underlying assets, thus increasing the value of subsequent real options. Therefore, the comprehensive value of a series of real options is not equal to the simple addition of the values of individual real options. He also studied the main factors that determine the interaction of real options. In recent years, this research on the correlation of real options has promoted the development of real options theory from theoretical research stage to practical application stage.
Fourthly, a comparative study of real options and traditional investment decisions.
The traditional capital budgeting scheme adopted by enterprises when considering investment decisions is accurate when evaluating relatively stable cash flow. However, it ignores the management flexibility after enterprise decision-making, and has been questioned by more and more theoretical workers and enterprise investors in recent years. The biggest difference between real options and traditional capital budget evaluation methods (such as the commonly used net present value method) is that real options attach great importance to the considerations in flexible decision-making.
Hayes and Gavin( 1982) pointed out that the number of companies using discounted cash flow assessment method increased from 1959 to 94% in 1975, but R&D expenses and capital investment decreased year by year, because the criteria of discounted cash flow assessment method often underestimated investment opportunities and led to decision-making.
Donaldson and Lorsch( 1983) believe that the future cash flow of the hypothetical investment scheme is certain, and the decision-makers have no chance to choose or modify it after making the decision, so the final result of implementation is very different from the actual business decision of the decision-makers. In fact, the market environment is changing rapidly, full of uncertainties such as competitors' entry, so the real cash flow after investment may be inconsistent with the pre-estimated cash flow. When the market environment and the whole business environment change or the uncertain factors disappear, the decision-makers will modify the investment plan to evaluate the value according to the new information, and the original investment decision may change accordingly.
Myers (1983) pointed out that there are inherent limitations when using discounted cash flow evaluation method to evaluate business or strategic options in investment planning. When the discounted cash flow evaluation method is used to evaluate more stable cash flow, the problem is not big; However, when evaluating the growth opportunities or intangible assets of enterprises, especially the value of R&D investment projects, the discounted cash flow evaluation method is not applicable because almost all of them are option values.
Baldwin and Clark( 1992) pointed out that the traditional capital investment decision-making method could not correctly evaluate organizational capacity. The development of organizational capacity can enable enterprises to develop and utilize market opportunities more effectively and achieve better business performance. They suggested that organizational competence should be regarded as the category of investment, and discussed its importance in strategic capital investment. Dixit and Pindyk (1995) think that although NPV method is simple to use, it implies a wrong assumption, that is, investment can be postponed, but most investment is irreversible and can be postponed.
In the changeable market environment, uncertainty and competitors' reaction often make the actual income different from the expected income. When new information or uncertainty gradually becomes clear, enterprises often find that different investment projects should have different management flexibility to modify the original investment. For example, you can postpone investment or expand, tighten or even give up this investment project. These can adjust the management flexibility of future actions according to environmental changes, making the probability distribution function of original net present value asymmetric and skewed, which comes from increasing possible upward value and limiting possible downward loss. When there is no management flexibility, the probability distribution of traditional net present value is symmetrical, and the expected value of net present value will meet the expected distribution; When the effect of management flexibility is significant, it can provide strategies to adjust future changes or change the original settings, thus bringing upward potential profits and limiting downward losses. In this skewed asymmetric probability distribution, the expected value will exceed the expected value of static net present value, and the excess is the premium of options, which reflects the value of management flexibility.
This paper puts forward a decision-making framework for evaluating capital with options, and conceptualizes and quantifies management flexibility. When considering the management flexibility of decision makers, the traditional net present value (or discounted cash flow) method is not abandoned, but the management flexibility is quantified through option evaluation to avoid the phenomenon that the value of investment projects is underestimated. Basically, the greater the uncertainty in the future and the longer the investment period, the higher the value of options. Traditionally, the greater the uncertainty, the longer the investment period and other factors will reduce the net present value of non-real options, but will increase the value of options (positive effect), thus offsetting the negative effect of reducing the net present value of non-real options and increasing the net present value of investment projects with real options.
In fact, the biggest difference between the option theory of capital investment and the traditional investment decision theory is that the former considers the "elastic" value implied by the so-called investment project. If decision makers want to correctly evaluate the true value of investment projects, they must consider this flexibility. The use of real options in capital investment decision-making is an extension of the information needed by discounted cash flow method method in capital budget evaluation procedure (considering management flexibility). Therefore, in the face of highly uncertain investment opportunity evaluation, the option evaluation method will provide more perfect decision-making scheme analysis results than the cash flow discount method, so as to better conform to the characteristics of investment projects and make correct investment decisions.