Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition

13

Option Valuation Concepts (1)

INTRODUCTION

As discussed in Chapter 8, the value of an option has two components:

• Intrinsic Value. This measures any money that can be released by exercising an option. It is either zero or positive. An option that has positive intrinsic value is said to be in-the-money.

• Time Value. This measures the value of an option over-and-above any intrinsic value it has.

Even if an unexpired option has no intrinsic value it will still have some time value. Time value reflects the chance that the option may move in-the-money before expiry. Generally speaking, this chance is greater:

• the longer the time remaining to expiry;

• the greater the volatility of the underlying asset (the more that returns on the asset fluctuate).

Taken together these factors - time to expiry and volatility - represent opportunities for the buyer of an option and risks for the writer. Time value is also affected by the level of interest rates. For example, the buyer of a call can deposit the strike price until the contract is exercised. Higher interest rates provide a greater income advantage in buying the call compared to buying the underlying asset in the first instance.

Calculating intrinsic value is easy, but time value is another matter. The problem is that, unlike (say) a Treasury bill, the eventual payout from an option is not fixed. It depends critically on what happens to the price of the underlying asset over the life of the contract. Option valuation requires a way ...