A recently settled FINRA Arbitration case was brought by an
investor who was sold a $2M call option on a basket of hedge funds by a large
investment bank. The case was notable
for two reasons. First, the investment
bank charged a 25 percent markup on the fair value of the option. This large amount was charged even though the
investment bank -- call it Investment Bank 1 -- simultaneously laid off all of its
risk by buying an equivalent call option from another investment bank -- call it Investment
Bank 2.
Even more interesting is that
the markup that Investment Bank 2 charged Investment Bank 1 was also passed along to the investor. Of course, it would have certainly been much
cheaper for the investor to buy the option directly from Investment Bank 2,
thereby avoiding the markup of Investment Bank 1. But Investment Bank 1 did not advise the
customer to do that, choosing instead to charge the additional markup in what
turned out to be a risk-less transaction for the bank.
The second interesting aspect of the case is how the option
was priced. All of the marketing
materials given to the client stated that the option would be priced on the
clients account statements according to the Black-Scholes model. The target volatility of the underlying hedge
fund basket was 6%. Numerous documents
showed that indeed the underlying hedge fund basket had 6% volatility.
However, when the option was sold to the
investor, it was priced as though the volatility was 15%. Higher volatility on the underlying asset leads
to higher option prices. The use of 15%
rather than 6% in the Black-Scholes model caused the price paid by the investor
to be 37% higher than the fair value calculated with 6% volatility. After the
option was sold at the artificially inflated price, internal documents show
that the volatility Investment Bank 1 used to price the option declined monotonically
from 15% to 6% over the ensuing two and a half years. This decline in the volatility caused a
reduction in the value of the option regardless of the performance of the
underlying basket of hedge funds.
At the end of the day, the investor paid $2M for an option
that had a value of approximately $1.1M.
The $900,000 overpayment by the investor was a combination of option
mispricing by the investment banks and two large markups.
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