Abstract

Option-based models have the potential to become useful tools for the analysis and economic assessment of contracts. In fact, these can generally be perceived as particular sets of embedded options. This paper focuses on two distinct cases and their pertaining models, with either one or both counterparties having the right to revoke their obligations under clearly stipulated conditions.
We show that, in an efficient market, a zero-cost contract featuring a unilateral right to cancel has to charge a fee for a cancellation, and at the same time it is due to bias the market price in favour of the option-issuer. The realm of mutually cancellable contracts is much more diverse, however. Under circumstances, such transactions may either be price-neutral, or they may combine various terms of asymmetric treatment of the counterparties.
Both analytical and numerical solutions are presented and discussed, providing useful insight into the economic workings behind this essential feature of various commercial transactions. This can help in their rational design as well as in their assessment by auditors, regulators and tax authorities. Brief mention is also made of the models’ potential use for econometric analysis, which can assist various policy decisions.

Key words: Cancellable contracts; Valuation; Embedded options.

JEL classification:D58, D81, G13

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