Does Option Theory Hold In Major League Baseball Contracts?

Gross, Alex
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University of Delaware
Major League Baseball teams use contract options in order to obtain the right to buy a player’s services for an extra year. Contract options seem to be theoretically similar to financial options, which reduce the risk of buying volatile assets. In this paper, I show that teams follow option theory as defined by financial options to an extent, both in terms of buying and exercising options. The sample of players consists of free agent hitters between the years 2003 and 2011. I use two separate probit regressions to model the option process. First, I estimate the probability that a new contract has a club or vesting option, with volatility being measured by the standard deviation of monthly on base plus slugging percentage for the previous season. I then estimate the probability that an option is exercised, using the difference between the real predicted salary and real option salary minus real buyout as an indicator of return to performance above the strike price. I find that the coefficient of standard deviation of monthly OPS is positive and significant at the 5% level and that the coefficient of log real salary-option difference is positive and significant at the 5% level, which shows that Major League Baseball teams do treat contract options like financial options to an extent. I conclude that teams could use options more efficiently by making player volatility a more impactful factor when deciding to buy options.