Document Type


Publication Date

Summer 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 consequenceof 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. The focus is on covered options, but the analysis also has implications for options in which the underlying property serves merely as a reference obligation and is owned by neither party to the transaction. The analysis 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 involve, in addition, a 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 obscures it; however, a comparison of option prices derived under the Black-Scholes model with 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.



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