Options and Buyouts

While guys like Barry Zito and Gary Matthews were signing long-term contracts to set themselves up for life, a bevy of major leaguers were signing one-year contracts this offseason. The one-year contract is typically the realm of the journeyman reliever or a veteran recovering from an injury, and teams take chances on these players hoping to catch lightning in a bottle. Particularly tempting is the possibility that a young player realizes his potential or an old player recaptures his past glory. A player who does is liable to cash in once his one-year term is over, so teams often hedge their bets by signing players to one-year contracts with a team option. That way, if a guy coming back from injury shows that he can still play, the team will have him under control the following year for a bargain salary. If the player doesn’t play well, the team can cut ties with him by buying out the option for a pre-arranged price.

Last December, I took a look at how option buyouts ought to be priced in baseball. In short, I found that there exists a “fair buyout price” where the expected value of the investment is zero. If the actual buyout price is less than the fair buyout price, then the team has successfully hedged its bets in such a way that the expected outcome—that is, the weighted average of all possible outcomes—is monetarily favorable to the club. (The details of the calculation are in the previous two articles, but it is worth noting here that this is not a zero-sum game. That is, if a team hedges its bets in such a way that the expected outcome is a net loss of $2 million, that doesn’t necessarily mean that the player has gained that amount.)

The fair buyout price can be determined so long as one has a) a reasonable projection of the player’s performance in the option year and b) knowledge of the uncertainty in said projection. The key results were:

  • As buyout prices approach zero, the risk for the team goes down. When the option has a buyout price of zero, the team assumes zero risk in the option year.
  • There is no fair buyout price for a player with a positive projected value in his option year. The team will always have a positive expected return on the investment regardless of buyout price.
  • High-priced buyouts can still be favorable to the team when there are large uncertainties in the player’s projection. Put another way, the fair buyout price will be high if there are large uncertainties in the projection.

    With all that in mind, let’s take a look at some of the one-year contracts with team options signed this offseason and their associated buyouts. Are teams successfully hedging their bets on the open market?

    As with the original articles, we’re going to be using Dave Studeman’s Net Win Shares Value (NWSV) as a valuation tool for performance. NWSV esentially tells us how much a player is worth above or below his actual salary; a NWSV of $2.3 million for a player with a $10 million salary means that a team should have had to have paid $12.3 million for the same production. For this study, we’re looking at one-year contracts signed this offseason, meaning we need projections and associated uncertainties for 2008. To this end, David Gassko has given us a sneak preview of his brand-new projection system which will debut in the THT 2007 Preseason Book. This is significant, as most other projection systems will give us 2008 projections but not the associated uncertainties. Finally, in order to compare dollar values across years, I’ve assumed that free agent salaries escalate at a rate of 10% per year.

    Let’s take a look at six of this offseason’s one-year-plus-team-option contracts.

    Moises Alou, Mets

    2007 salary: $7.5 million
    2008 salary: $7.5 million
    Buyout price: $1.0 million

    Contract details

    After a few successful (and age-defying) years is San Francisco, mano-urinophile Moises Alou signed with the Mets this offseason. Our projection system thinks that Alou will garner something like 4.2 WSAB should he play in 2008; given his potential salary, that would be a NWSV of -$0.25 million. But his 25th percentile projection is much worse, at -$3.1 million, and his 75th percentile projection is much better, at $2.6 million. As we saw earlier, large uncertainties translate to high fair buyout prices. In Alou’s case, the fair buyout price is a whopping $5.7 million dollars, meaning the Mets got themselves a very good deal with the buyout on the option. If they make decisions rationally, they have a good chance to come out ahead on this deal.

    Rod Barajas, Phillies

    2007 salary: $2.5 million
    2008 salary: $5 million
    Buyout price: $0.5 million

    Contract details

    Rod Barajas represented the worst tendencies of Buck Showalter to many Ranger fans. Despite struggling to post a .300 on-base percentage, Showalter continued to play Barajas over the younger and better (in 2006 at least) Gerald Laird. Barajas signed with the Phillies to don the tools of ignorance after Mike Lieberthal moved on. Our projections are somewhat kind to Barajas, predicting that he’ll post only a slightly negative NWSV in 2008 should his option be picked up. Combined with a relatively large uncertainty, the fair buyout price is $4.8 million, which is almost the price of the option itself! Count the option year as a win for the Phillies.

    Why is the fair buyout price so high for these two players? A big reason is that the projections come with a good deal of uncertainty. That’s not a knock on the projections, it simply speaks to the difficulty in predicting the performance of baseball players two years down the line. When the projection is uncertain in either direction, it’s not a bad thing for the buyout price to be high. If the player totally bombs, there’s only so much money that a team can lose (that is, the buyout price). But if a player really turns a corner and is fantastic, the team can save a ton of cash simply by exercising the option and getting production for below-market value, and there’s no theoretical upper limit on what this production—and therefore, the savings—might be.

    Joe Borowski, Indians

    2007 salary: $4.0 million
    2008 salary: $4.0 million
    Buyout price: $0.25 million

    Contract details

    Darren Oliver, Angels

    2007 salary: $1.5 million
    2008 salary: $2.0 million
    Buyout price: $0.25 million

    Contract details

    Joe Borowski and Darren Oliver were brought in to bolster the bullpens of two American League contenders. Borowski has had a mixed track record of success as a reliever, sprinkling some dominant years with the Cubs with injury and ineffectiveness. With the retirement of Keith Foulke, he may have the inside track on the closer’s job in Cleveland. Oliver, on the other hand, only recently made the full-time switch to the bullpen as a lefty reliever. His year for the Mets was a relative success. Both were signed to reasonable contracts this winter, with Borowski receiving what I call the “Closer Premium.” The projection system is very pleased with both pitchers, predicting above-replacement level performance for both in 2008. Should their options be picked up, Borowski projects to be fairly compensated in 2008 (NWSV ~ 0) and Oliver projects to be a bargain (NWSV ~ $3.4 million!). That, combined with the relatively low uncertainty in their projection, leads to a bizarre conclusion: there is no fair buyout price! Even if the buyout prices were the value of the 2008 salary itself, the teams would still have successfully hedged their bets on the buyouts. That the buyout price is a very low $250,000 only enhances the bargain.

    The fact that there is no fair buyout price means that both the Angels and the Indians—whether inadvertently or intentionally—chose pitchers with good projections and negotiated very favorable salaries in the option year. Kudos to both teams!

    Chris Reitsma, Mariners

    2007 salary: $1.35 million
    2008 salary: $2.7 million
    Buyout price: $0.7 million

    Contract details

    Hoping to bolster their relief corps after trading Rafael Soriano (I can hear Jeff Sullivan sighing from here), Seattle signed the struggling Chris Reitsma. The projection doesn’t like Reitsma to provide much beyond bench-level production in 2008. Even though the buyout is a good fraction of the 2008 salary, the calculation shows that the fair buyout price is $0.8 million. The expected return on this investment is basically zero.

    Shea Hillenbrand, Angels

    2007 salary: $6.0 million
    2008 salary: $6.5 million
    Buyout price: $0.5 million

    Contract details

    Noted jumper of sinking ships Shea Hillenbrand signed a one-year deal to join a DH/1B/3B rotation for Los Angeles. He’s at the point in his career where he’ll provide a solid-but-empty batting average with little or no defensive value, what baseball euphemists call “Professional Hitter.” He’s projected to be barely an above-bench player in 2008 with a NWSV of around -$2.5 million should the option be picked up. There is a decent (if not good) chance that he’ll hit .300 with power (if not patience), so the option does have the potential to be a bargain. On the other hand, no matter how bad he is, the Angels can always cut their losses for the low cost of $500,000. Since the projection comes with a decent degree of uncertainty, the fair buyout price is $1.1 million, meaning that the Angels came out slightly ahead on the terms of the option. But considering that the option automatically vests if Hillenbrand hits 600 plate appearances, it’s hard to call this a definitive win for the Angels.

    In general, teams appear to be doing a good job of hedging their bets when it comes to pricing options and their buyouts on one one-year deals. In fact, most can be more agressive with their buyout prices if it will help lure the player away from another suitor. Barajas and Alou are signed well below the fair buyout price, and the option-year salaries for Borowski and Oliver make them bargains regardless of the buyout price. It is less clear whether the Reitsma and Hillenbrand options are net positives for their respective teams, but the option/buyout structures in both of those cases are far from ugly. Whether or not teams are consciously structuring these option/buyout contracts is unknown. It may be that they simply use heuristics—but if so, those heuristics seem to be doing the trick.

    References & Resources
    MLB4u has an unfortunate name and interface, but it is an excellent source of contract details. Cot’s Contracts it’s also a great source for contract information; has a nicer interface but no search feature.

    THT is a collaborative effort, so I would be remiss if I didn’t thank Dave Studeman and his NWSV calculator and David Gassko’s new projection system. For more information on how NWSV are calculated, you can check out Dave Studeman’s article. David Gassko’s projection system will be debuting in the THT 2007 Preseason Book. Keep your eyes on THT during the coming week for details.

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