CFM11084a - Understanding derivative contracts: types of derivatives
Options: intrinsic value and time value
Intrinsic value
Look back at the example in CFM11082. When the option over the
Oakway shares was granted, it was in the money – the strike
price was 220p, but Oakway shares were trading at 225p.
Suppose that we are looking at an American-style option,
which can be exercised at any time up to and including the expiry
date. If the company exercises the option then and there, it would
make a profit of 5p per share, or £500 on 10,000 shares.
£500 is the intrinsic value of the option.
Suppose that the strike price had instead been set at 225p,
so that the option was at the money when it was granted. It would
have no intrinsic value. And if the strike price had been set at
230p, so the option was out of the money, it would still have zero
intrinsic value – there is no such thing as negative
intrinsic value.
Finally, suppose we go back to the original facts of the
example in CFM11082, and assume the option is a European option,
exercisable only after a period of 6 months. The strike price is
220p, and the market value of Oakway shares is 225p. The intrinsic
value of the option will be slightly less than £500, because
the company can only receive the pay-out in 6 months’ time,
and £500 payable in 6 months is worth less than £500
today. It is therefore necessary to discount the £500 to its
present value.
Time value
Would the company still have paid a premium to acquire the
option if it had been out of the money? It might have done. If the
strike price had been 230p, there is nevertheless a chance that, in
6 months’ time, Oakway shares will have risen above that
figure, so the company could make a profit on exercising the
option.
The time value of an option is, in simple terms, what that
chance is worth. This will depend on three things:
- How long the option has to run before it expires. The nearer an option gets to expiry, the less chance there is of an out of the money option moving into the money (or an in the money option moving more deeply into the money). So its time value will decrease as the expiry date draws nearer.
-
The volatility of the underlying asset. Volatility
is a measure of the ‘scatter’ of the different values
which the price of the underlying asset might take. Suppose, for
example, a call option over shares will only move into the money if
the share price rises from 300p to 400p. There is much more chance
of this happening if the volatility is high than if it is low.
It is, of course, the future volatility that matters but this cannot be known. Future volatility is often assumed to be the same as in the past. So you might assume it more likely that the price could rise from 300p to 400p if the price had fluctuated between 250p and 500p in the previous year than if the price had never fallen below 290p or risen above 320p. The more volatile the price of the underlying asset, the greater the time value of the option. - Market rates of interest. Normally someone who buys an option will pay a premium up-front. They will either have to borrow money to do this, or withdraw money from existing investments. So they will need to factor the time value of money into the price they are prepared to pay for the option.
If an option is out of the money, it will only have time value. If it is in the money, its value will be a combination of intrinsic value and time value.
