Financial Options in the Real World - An Economic and Tax Analysis
52 Pages Posted: 29 Aug 2009 Last revised: 20 Oct 2010
Date Written: October 18, 2010
Many of the consequences of issuing and purchasing options on publicly traded property have been well understood since Black and Scholes developed a model for option pricing. No model of options, however, provides an accurate economic analysis of the actual transactions that issuers and purchasers engage in when options are bought and sold. One consequence of this gap in understanding is that the rules for taxing options remain poorly developed.
This article provides a transactional analysis of option sales for the first time. It demonstrates that while all options have as one component a swap of variable risks or returns on the underlying property for a fixed payment, “in-the-money” options contain, in addition, a simple forward transfer of the benefits and correlative burdens of a part of the underlying property that is equivalent to a forward sale of that part. Commentators have not identified this embedded forward sale because the payment arrangement between the parties to the option transaction masks it; however, a comparison of option prices derived under the Black-Scholes model and the theoretical prices of such forwards demonstrates that the transactions are identical. The analysis also illuminates the relationships between options and other common financial transactions, such as collars, and it permits a clear assessment of the advantages and disadvantages of possible tax rules for financial options.
Keywords: taxation, options
JEL Classification: E62, H24, H25, K34
Suggested Citation: Suggested Citation