Options as Silver Bullets: Valuation of Term Loans, Inventory Management, Emissions Trading and Insurance Risk Mitigation using Option Theory

TL;DR

This paper develops option-based models for pricing long-term contracts in securities lending, inventory, emissions trading, and insurance, demonstrating their practical use and potential for improved risk management and operational synergy.

Contribution

It introduces a novel application of derivatives theory to long-term contract valuation, with a heuristic for parameter estimation directly from historical data.

Findings

Models enable better risk mitigation in various financial sectors

Numerical simulations confirm practical applicability

Heuristic improves valuation accuracy and robustness

Abstract

Models to price long term loans in the securities lending business are developed. These longer horizon deals can be viewed as contracts with optionality embedded in them. This insight leads to the usage of established methods from derivatives theory to price such contracts. Numerical simulations are used to demonstrate the practical applicability of these models. The techniques advanced here can lead to greater synergies between the management of derivative and delta-one trading desks, perhaps even being able to combine certain aspects of the day to day operations of these seemingly disparate entities. These models are part of one of the least explored, yet profit laden, areas of modern investment management. A heuristic is developed to mitigate any loss of information, which might set in when parameters are estimated first and then the valuations are performed, by directly calculating valuations using the historical time series. This approach to valuations can lead to reduced models errors, robust estimation systems, greater financial stability and economic strength. An illustration is provided regarding how the methodologies developed here could be useful for inventory management, emissions trading and insurance risk mitigation. All these techniques could have applications for dealing with other financial instruments, non-financial commodities and many forms of uncertainty.