Tuesday, February 2, 2010

Greekonomics 103 - Option Value

Many finance types who hoard their miles always talk about the "option value" pf having their miles, and in a rudimentary sense, this is the case. Having the miles gives you the option to either purchase a ticket or use miles for the ticket. However, what they typcially overlook is that in general, this option value is declining over time. The reason for this is based on a fundamental difference in how stock options are valued versus how I might value the miles in my account. Back in the 1970s, two prominent economists (Fischer Black and Myron Scholes) published an acedemic paper on how options are priced in the securities markets. In the interest of not having your eyes glaze over with literal "Greekonomics" in the form of the Greek letters used in their formula, suffice it to say that their option pricing model was based on a number of assumptions, one of which is that the price of the underlying security "follows a Geometric Brownian Motion with constant drift and volatility". In layman's terms, this means that pricing of the underlying security will be fairly random. And THERE is where the mileage option gurus have made their error, since we all know that when it comes to mileage awards, the only direction in terms of mileage needed for an award is up - meaning that the value of your miles is constantly drifting DOWN. This is not to say that you should burn through miles the instant you get them, but rather to be thoughtful and to occasionally follow the less scientific approach espoused by the phrase "smoke 'em if you got 'em."

NB: I don't espouse to be an expert on option pricing or statistical modeling using Geometric Brownian Motion. There are plenty of resources on the web that can do this topic justice. However, I'd be remiss if I didn't give a tip of the Greekquentflyer hat to Myron Scholes, for whom the aforementioned option pricing model is named and who won, with Robert Merton, the Nobel Prize in Economics in 1997. I had the privilege of working with Myron in the late 1980s, and his influence on my career trajectory was immeasurable.

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