7.8 Pricing and valuations of options Flashcards
Moneyness
For an option that is initiated at time ) and matures at time T, let time t be any point between those two dates.
An option’s value at time t depends on the difference between its exercise price, X, and the spot price of the underlying at that time, St
An option’s exercise value, also known as its intrinsic value
the amount that the owner would earn by exercising the option immediately
Because options have nonlinear payoff, this value will either be positive or zero, but it can never be negative
An option’s time value represents
the potential for beneficial movements in the price of the underlying
An option that is currently out of the money has time value because it could move into the money with a change in the price of the underlying.
And an option that is already in the money also has time value because it could move even further into the money.
Time value is positively related to the volatility of the underlying. A more volatile underlying means that there is a greater likelihood of a beneficial price movement. Similarly, time value is positively related to the amount of time remaining until maturity because this increases the opportunity for a beneficial movement in the price of the underlying
time value decay.
As an option moves toward maturity, its time value approaches zero
Factors Affecting Option Value
Value of the Underlying
Exercise Price
Time to Expiration
Risk-Free Interest Rate
Volatility of the Underlying
Income or Costs Related to Owning the Underlying
With respect to a European call option, which of the following is least accurate?
A
The value of the option is directly related to the exercise price
B
The value of the option is directly related to the risk-free interest rate
C
The value of the option is directly related to the volatility of the underlying
A
The value of the option is directly related to the exercise price
Which of the following statements is most accurate? Holding all other factors constant, the relationship between time to expiration and the value of a European put option:
A
is always direct.
B
is always inverse.
C
may be direct or inverse.
C
may be direct or inverse.
A longer time to maturity generally increases (and never reduces) the value of a European call option. As the time to expiration increases, the issuer gains money because the present value of the strike price decreases over time.
The relationship between time to expiration and the value of a European put option is usually direct as well. However, it is possible for this relationship to be inverse if the put option is deep in-the-money and the risk-free rate is relatively high.
