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On options & epidemics.

Article Excerpt
The pricing of call and put options seems to have nothing in common with attempts to control the spread of sexually transmitted diseases. But it turns out that, in both cases, identifying and influencing the variance of a probability distribution can be more important than identifying and influencing the mean.

It is easy to see that additional volatility in the underlying asset of a call option leads to greater option value. An option holder can cash in on the added gains from an upward fluctuation but loses no more if the price fluctuates wildly downward. For example, if you own an option to buy a share of Google stock at $200, you want Google's stock price to fluctuate. In fact, option holders should be willing to trade a lower mean for a higher volatility. A person holding the Google call should prefer a world where there is an equal (1/3) chance that the price of Google stock will end up at $100, $200, or $300 than a world where there is an equal (1/3) chance that the price of Google stock will end up at $200, $210, or $220. Even though the latter distribution has a higher mean ($210 versus $200), the higher volatility of the former distribution has a bigger impact on the option value. Under the first distribution, the call option will be worth $33 (.33 x $100). The second distribution, even though it has a higher expected stock value, produces a lower call value of $10 (.33 x $10 + .33 x $20).

A folk theorem of finance theory is that whenever you identify an implicit option, there is almost always an interesting volatility story to tell. And there are implicit, or 'real,' options in all kinds of real-world settings. For example, consider an extremely stylized nuisance dispute. Imagine that Scholes...

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