Rational Pricing of Options during the South Sea Bubble: Valuing the 22 August 1720 Options
We present evidence of rational pricing South Sea Company liabilities and call options written on South Sea shares. A previously unstudied dataset on South Sea share options is presented. The Company's capital structure of the firm is redefined so that the application of modern financial economic theories can be applied to its valuation. We present evidence that a significant portion of South Sea equity liabilities was in the form of share warrants and conversion (from bonds to shares) privileges and should be so valued. Finally we present a model of the cross-sectional behaviour of share prices, South Sea Company debt and call option values. The model is calibrated and simulated in order to produce estimates of the required return on the Company’s debt and the volatility of the firm’s asset values. We conclude that the jointly estimated value of the firm, its constituent liabilities, third-party call option values and implied volatilities are consonant with rational pricing behaviour during the Bubble, although the model requires extension in several directions in order to present a more complete picture of the South Sea Bubble.
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- Garber, Peter M, 1990. "Famous First Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 35-54, Spring.
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