Home Economics Derivative Markets

## Intrinsic value and time value## IntroductionThe • Intrinsic value (IV). • Time value (TV). Therefore:
## Intrinsic valueThe difference between the (EP) is termed the exercise price of the option (IV) of the option.intrinsic value As seen, there are 3 categories in this regard: • In-the-money (ITM) options (have an intrinsic value) • At-the-money (ATM) options (have no intrinsic value) • Out-the-money (OTM) options (have no intrinsic value). ITM options are: • Call options where: SP > EP • Put options where: SP < EP. Clearly, the following options have no intrinsic value (OTM): • Call options where: SP < EP • Put options where: SP > EP • Call options where: SP = EP • Put options where: SP = EP. Thus: IV = SP - EP (call options); positive when SP > EP IV = EP - SP (put options); positive when EP > SP. A summary is provided in Table 2.
## Time value
The (P) of an option and its premium (IV):intrinsic value P = IV + TV TV = P - IV.
Option = call option Underlying asset = ABC share Underlying asset spot market price (SP) = LCC 70 Option exercise price (EP) = LCC 60 Intrinsic value (IV) = SP - EP = IV = LCC 70 - LCC 60 = LCC 10 Premium (P) = LCC 12 Time value (TV) = P - IV = TV = LCC 12 - LCC 10 = LCC 2. The option has If the option is exercised now (i.e. at LCC 60), the intrinsic value is gained, probability that the intrinsic value could increase between the time of the purchase and the expiration date. It will be apparent that as an option moves towards the expiration date, time value diminishes, and that at expiration time value is zero. This is portrayed in Figure 7.but time value is forgone. ## Option valuation/pricing## IntroductionThere are two main option pricing / valuation models that are used by market participants: • Black-Scholes model. • Binomial model. Below we also mention the other pricing models and define the so-called "Greeks". ## Black-Scholes model## IntroductionThe Black-Scholes model was first published in 1973 and essentially holds that the fair option price (or premium) is a function of the probability distribution of the underlying asset price at expiry. It has as its main constituents the following (see the valuation formula below)46: • Spot (current) price of underlying asset (assume share) (SP). • Exercise (strike) price (EP). • Time to expiration. • Risk free rate (i.e. treasury bill rate). • Dividends expected on the underlying asset during the life of the option. • Volatility of the underlying asset (share) price. Each of these elements is covered briefly below. ## Spot (current) price of underlying asset and exercise priceIf a call option is exercised the SP - EP (obviously if SP < EP, there is no profit). Call options are therefore more valuable as the SP of the underlying asset EP - SP (obviously if EP < SP there is no profit). Put options are therefore more valuable as the SP of the underlying asset ## Time to expirationThe longer the time to expiration the more valuable both call and put options are. The holder of a short-term option has certain |

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