Any of you remember this movie called “My Best Friend’s Wedding”? If you don’t, here is a brief description of the plot. Julia Roberts and Dermot Mulroney (had to look up imdb to remember his name) have this agreement that if they are both single as of her 28th birthday, they will get married to each other. As it happens, 3 weeks before that, the hero announces that he’s found a woomaan and is going to get married to her, much to the dismay of the heroine, who now puts fight to somehow spoil this new relationship.
I was thinking of this kind of arrangement as a financial product. Actually, the movie has what I call as the “European version”. More complicated is the “American version” which I describe here. Basically I give you the OPTION to marry me on any day before my 28th birthday (6th Dec 2010). That would be simple enough to “price” (or “value”, to put it in layman’s terms) – it is a standard American option. However, let me add this twist into it. I also reserve the right to withdraw this option on any day before expiry or exercise.
So basically some day before my 28th birthday I can wake up and cancel this option that I’ve given you. Now the challenge is to price this. One thing that is obvious is that the value of this is now less than the value of the pure American option. But pricing it is a challenge (though, thinking about it carefully, it shouldn’t be too hard to solve. I think we can use option-on-option fundaes in order to price it, but still it’s nontrvial).
The European option, of course (as it is done in My Best Friend’s Wedding) easier to price. Basically, there are two events that need to happen on the day of expiry for the option (ok technically it isn’t an option since if these two events happen, then the parties are forced to execute the contract) and so it can be easily modeled using a two-factor model. The American, as we discussed, is tougher (though I’m sure that if I were to present this problem to my colleagues, they’d solve it in a jiffy).
So the reason I’m writing this is that I’m planning to enter this kind of a deal with someone. And I’m wondering if it’s better to enter into a European deal or into an American. Remember that if it is the “American” deal, I’ll be giving away the option (to marry me before either my 28th birthday or I withdraw the option) for free. Considering this, under what conditions should I try to sign the European contract, and under what conditions should I give away the American?
Also, how does the pricing of the American option change if I’m allowed to give it away to more than one person (with the understanding that as soon as one person exercises the option, I withdraw the option from all the other people I’ve given it to). And typically, will I be able to get more benefit in total by giving away this American option to a number of people than if I give it away to one person (assuming I’m indiffernet between all these people with respect to marriage).
Ok it’s late in the night and it’ s my third post in the last 1 hour, so it might be a bit muddled up. Also, you might find it a bit too technical (remember that I’m a quant). Nevertheless, I hope I’ve been able to communicate what I wanted to communicate. And am looking forward to your advice on this.
3 thoughts on “Pricing My Best Friend’s Wedding”
what does the buyer stand to gain here…how is the risk/volatility of withdrawing contract measured …the pricing shld depend a lot more on that then by the classic model…more number of persons to bid shld make the terms of pricing easier
Modeling this is no fun.
What you need is a market – think swayamvar but with an open outcry market floor where you take bids for the options.
Giving the option to more than 1 person – the value also changes depending on whether each of those parties know about the other option holders. For some, it may go to zero right?