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The Efficient Design of Option Contracts: Principles and Applications

62 Pages Posted: 3 Mar 2004  

Avery W. Katz

Columbia University - Law School

Date Written: March 2004

Abstract

The law of contracts has often treated options quite differently from other contractual transactions; for example, the characterization of a transaction as an option contract calls forth specially required formalities, but on the other hand often has the effect of releasing parties from doctrinal limitations on their contractual freedom, such as the duty to mitigate damages or the rule that holds excessively high liquidated damages void as penalties. Such differential treatment is challenging to explain from a functional viewpoint, in part because all contracts resemble options to the extent they are enforceable in terms of monetary damages, and in part because contracts that are nominally structured as explicit options can be close economic substitutes for contracts that are nominally structured as unconditional.

This essay sets out a theoretical account of the efficient design of option contracts - one that explains how contracting parties should strike the balance among option premium, option life, and exercise price, in order to maximize the expected surplus from their transaction. It shows that the tradeoffs between these various aspects of option contracts can affect the parties incentives to acquire and disclose information, to invest in relation-specific investments, and to take efficient precautions against the event of breach. It then goes on to develop an organizing framework for private parties choosing whether and how to structure their contractual arrangements as options, and for policymakers choosing whether or how to regulate such private choices. In short, the appropriate balance between option premium, option life, and exercise price will depend on the relative importance that the one attaches to these various dimensions of incentives.

Keywords: Contract law, option contracts

JEL Classification: K12, K20

Suggested Citation

Katz, Avery W., The Efficient Design of Option Contracts: Principles and Applications (March 2004). Columbia Law and Economics Working Paper No. 248. Available at SSRN: https://ssrn.com/abstract=512146 or http://dx.doi.org/10.2139/ssrn.512146

Avery W. Katz (Contact Author)

Columbia University - Law School ( email )

435 West 116th Street
New York, NY 10025
United States
212-854-0066 (Phone)
212-854-7946 (Fax)

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