One of the hallmarks of an alternative investment is an option-like payoff – a return distribution that is truncated or skewed. If that is the case, then the ubiquitous penny and quintessential nickel could be the most popular alternative investments in the United States (and, we suspect, in many other countries around the world in similar forms).
According to an article by Espen Haug and John Stevenson, physical currencies – particularly those made from copper and nickel contain an option that is close enough to the money to have a material value and has even been in the money in the recent past.
Haug and Stevenson point out that pennies and nickels can be converted into electronic money at their face value, but that they also contain copper and nickel that, in 2007, was worth more than the denominations themselves. Put another way, pennies and nickels are really just long positions in copper and nickel combined with a put option on each with strike prices of one cent and five cents. If the price of the copper in a penny goes above one cent, the option is worthless. Likewise, if the price of the nickel in a nickel goes above five cents, the option is also out of the money.
Most of the time, these put options are way in the money. In fact, for paper money they’re almost always in the money since the cost of the paper itself is negligible (assuming that the paper banknote is not directly exchangeable for some other commodity such as silver). As Haug and Stevenson point out, however, even the paper in a banknote can have a value that surpasses the denomination in cases of hyperinflation.
“It is interesting to note, however, that during the inflation period in Germany from 1923-1924, the face value of the paper money at some point was probably lower than that of the physical paper itself. At the peak of this time of hyperinflation, burning money was less expensive than buying firewood; that is, the embedded option in paper money actually went out-of-the money.”
We found this 100 trillion Zimbabwe dollar note going for nearly US$8 on eBay today. So it seems that like worthless share certificates, worthless banknotes contain a put option with a strike price based on their value as souvenirs. (Using the Zimbabwe experience as a guide, this would mean that the entire US currency supply contains puts totaling between six and seven cents. Okay not much of a fall-back position, we concede.)
Suffice to say, coins are more likely to contain out of the money options. In fact, in 2007, the value of the nickel in a US nickel was about 9 cents. Today it’s only around 2 cents.
But don’t forget that the value of any option is based on the volatility of the underlying asset. So although copper and nickel have come down from nosebleed territory in the past 2 years, the put option has value even when its out of the money.
According to Haug and Stevenson, this is one of the reasons why people refrained from melting down their nickels in 2007. (Another likely reason was that it can be complicated and time consuming to set up an industrial smelter in your back yard.)
But just in case you did happen to own a nickel smelter, the US government made it illegal to melt or export coins beginning in December 2006. (We assumed said melting would amount to defacing a currency, which was already illegal, but perhaps not.)
Haug and Stevenson describe this law as a short call position on the metals’ value. So basically a nickel ends up being a (each with strike prices of 5 cents) essentially removing both the upside and the downside – leaving the investor with exactly 5 cents.
Apparently, about $2.5 billion of US nickels have been minted since 1946. While those nickels were worth close to $5 billion in 2007, they are – even today – worth more than $2.5 billion if you view them as base metal plays instead of everyday annoyances.