Ignoto on the Corp Fin Curriculum

Ignoto read my lament about the corp fin curriculum  and responds with some provocative advice:

--Optionality is everything - frankly, I'd start with that. A lender writes a put on the value of an asset or enterprise and is paid a premium for doing so; an insurer writes a put on the value of whatever is being insured and is paid a premium for doing so; an equity holder writes a call on the value of an asset or enterprise and pays a premium for doing so. Everything derives from those concepts - securitization, swappery, you name it. (Exam question: deconstruct the 3-7% attachment-point tranche of Goldman Sachs Pile of Dung CDO 2006-1 into a set of options. Determine which German banks had the ability to properly assess this tranche. Show your work.)

--Related to the previous point, Black-Scholes is of high utility from a teaching aspect, especially right at the start of the course. And not for the formula - who cares what the formula is - or for its shortcomings - as plentiful as they are - but for parsing the five elements of the formula (risk-free rate, asset price, strike price, time to maturity, and volatility) and how each affects the value of the option. As you go through other elements of corp-fin, you can keep coming back to this: how does a savvy private equity investor retain the option value of its equity in a company it owns that is struggling? Why would a tech company be more inclined to issue convertible bonds than a utility?

--A key element of understanding corporate finance and the securities markets is understanding market participants' different time horizons, risk constraints, accounting conventions, and incentive structures. The failures you mention in the blog entry can all be picked apart by assessing those factors - and students may be able to discern why hedge funds are able to make money in unique ways by arbitraging away the mispricings that exist due to these disparate needs and constraints.

Once you get those concepts in students' minds - optionality, incentives, and market structure - the rest tends to flow pretty naturally. And the sooner people look at these, the better equipped they are to avoid narrowing their focus too tightly and missing the financial forest for the trees.

I'll take it to heart as well as to mind and indeed, option pricing has been working its way up through the pack for several years now though I prefer to do it with binomials because I think the core intuition is the same and it scares thetroops less.  Hope he's kidding about the Pile of Dung CDO.