Introduction
XPOs are pure "vanilla," American-style options with no
expiration date. Like traditional American options:
· they can be executed
by the buyer at any time
· they come in the form of Calls (the
right to buy) and Puts (the right to sell)
· these options will sell for
different prices at different strike prices (the "strike price" is the price at
which the parties agree to buy or sell)
· the XPO Option price is based on the
type of option, the strike price, the price of the underlying
· asset (the asset to be bought or
sold), the volatility of the underlying asset and the risk-free interest rate
Examples of uses and advantages of XPOs
XPO Calls:
· Because the
option does not expire, an XPO Call allows an investor, speculator or hedger
permanently lock-in future capital gains in
the present by selling the Call option
· The XPO Call
at a non-zero strike price will always sell at a discount to the underlying
asset because of Arbitrage Pricing Theory.
· Because
the XPO Call guarantees the right to buy at a particular price, XPOs provide a
hedge against the risk of inflation
XPO Puts:
· An XPO Put allows an investor,
speculator or hedger to protect financial assets from the risk of price
declines - permanently - because of the right to
sell at a predetermined price
· Because the XPO Put guarantees the
right to sell at a particular price, XPOs provide a hedge against the
risk of deflation
The sale (short) of the XPO Call and XPO Put allows an investor
to raise funds on a tax-deferred basis These funds can be used for hedging,
reinvestment in the underlying asset, or an alternative investment for hedging.
In its simplest form, XPOs form a bridge between the expiring and
non-expiring markets. They provide for the "equitization" of futures contracts
because the XPO provides the right to buy or sell without the dual liability of
futures contracts or the expiration and delivery risk associated with these
products. XPOs provide all the benefits of an option contract without the risk
of expiration and a reduction in trading costs by eliminating the market
inefficiencies that exist when options or futures contracts need to be rolled
over.
The sellers of XPOs generate cash on a tax-deferred basis in
order to hedge a portfolio, lock-in a capital gain, or speculate on future
price movements. In short, XPOs are an improved product for every financial
transaction involving the sale or purchase of an asset for investment,
speculation or hedging.
Pricing
In 1973, Nobel-prize-winner Robert Merton provided the means to
price an XPO Put. By recognizing that at an exchange-equivalent strike price in
the currency markets, a dollar-yen call (the right to "call away" yen for
dollars) is equivalent to a yen-dollar put (the right to "put" dollars in
another investor's portfolio in exchange for yen), we recognize that Merton's
dollar-stock XPO put (the right to put stock in another investor's portfolio in
exchange for dollars) was also a stock-dollar XPO call (the right to call away
dollars in exchange for stock). We use this transitive theory to price XPO
Calls either directly or through calculation of the XPO Put and transformation
to calculate the price of the XPO Call. Dr. William Margrabe, former professor
at The Wharton School at The University of Pennsylvania, has developed a
computer program that will assist market participants with XPO pricing.
Tax Treatment
The treatment of gains and losses for options, even long-dated
options, is well established and we expect the tax treatment of XPOs to be
similar, if not identical, to other long-term investments.
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