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Introduction

Welcome to the Knowledge Check. If you have prior knowledge of Options Introduction to Option Valuation, try the Knowledge Check. A perfect score is no guarantee that you know everything covered in the tutorial, but a less than perfect score will help you identify any knowledge gaps. If the subject of this tutorial is new to you, the Knowledge Check will indicate the level of the information that you're about to encounter. You may think you don't know much about this area, but you might surprise yourself!

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Question 1 of 5 A call option on widgets expires tomorrow. It has a strike price of EUR 100. The current market price of widgets is EUR 90. Assume that interest rates are zero, widgets are non-income producing, and there is no holding cost. Which of the following statements is true? The option is in the money. The option is at the money. The option is out of the money. Question 2 of 5 An agent owns a USD 110 call option on widget futures. The price of the widget futures contract is USD 100. The option costs USD 3. What is the time value of this option? Zero USD 10 -USD 10 USD 3

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5. Question 3 of 5 All other things remaining equal, which of the following would increase the value of a put option on a futures contract?

A decrease in the maturity of the option An increase in the underlying price of the futures contract An increase in the volatility of the futures contract Question 4 of 5 An American-style call option has a strike price of EUR 50, and three months to expiry. Interest rates for the period are 10%, and volatility is 5%. The current price of the underlying asset is EUR 75. Should the option be exercised early? Yes No 7. Question 5 of 5 Which of the following is the correct put-call parity equation? 6.

OBJECTIVES

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On completion of this tutorial, you will be able to:

explain when an option is 'in' or 'out' of the money

show how an option price is broken into two components: intrinsic value and time value describe the major influences on option values outline the upper and lower boundaries of option prices and explain the factors affecting the exercise decision describe the 'put-call' parity relationship

Prerequisite Knowledge Prior to studying this tutorial, you should have simple familiarity with the discounting of future values, and a good understanding of the concepts outlined in the following tutorial:

Options An Introduction

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Forward Prices How do forward prices affect 'moneyness'? Consider a one-year European call option struck on widgets at USD 105. The underlying price is currently USD 100, while the forward price is USD 110. The 'moneyness' of the option can be expressed relative to the spot and the forward price. Relative to the spot price This option is 'out of the money' (OTM), because it would not make sense to exercise at USD 105 when the market price was only USD 100. However, this option is not exercisable now; it is exercisable in one years time. Relative to the forward price This option is 'in the money' (ITM) it would make sense to buy widgets at USD 105 if the price was actually USD 110.

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Different markets have different conventions; equity markets tend to relate option strike prices to spot prices, while interest rate markets tend to focus on forward prices. In the foreign exchange market, American-style options usually relate the strike to the spot FX rate, while European-style options usually relate the strike to the forward FX rate. Rather than attempting to use different practices in different markets, it is best to be precise; rather than referring to an at-themoney option, it would be better to use the terms 'at-the-money forward' or 'at-themoney spot'. Note that for options on futures, the debate is irrelevant; futures prices are already forward prices so 'moneyness is a simple

comparison between strike price and market price. We will sometimes take advantage of this by using imaginary futures contracts in our example.

13. Option Moneyness Option moneyness is summarized in the following table:

14. Moneyness Example 1 A call option is written on a futures contract. It has a three-month maturity and a strike price of EUR 100. Three-month interest rates are 4%. The current futures price is EUR 100. What is the option moneyness? In the money At the money Out of the money Moneyness Example 2 A put option is written on an underlying asset. It has a one-year maturity and a strike price of EUR 100. The asset generates no income, and has no ownership or storage costs. One-year interest rates are 5%. The current asset price is EUR 100. Which of the following statements is true? The option is in the money 15.

forward. The option is at the money forward. The option is out of the money forward. Components of Option Value 16.

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Intrinsic Value A 3-month American call option on a hypothetical futures contract has a strike price of EUR 100. The current price of a futures contract is EUR 90. The option costs EUR 5. Assuming that interest rates are zero, what is the intrinsic value of this option? EUR 5 -EUR 10 Zero -EUR 5

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Factors Affecting Option Value An Overview It is comparatively easy to calculate the intrinsic value of an option, but much harder to estimate the option's time value. This is because time value includes the value of 'optionality' (considered either as the additional premium required by an option seller to compensate for the risk, or the amount a buyer is willing to pay for the possibility of future payoffs). So how are fair prices for options obtained? Precise calculations may involve the use of a sophisticated pricing model. There are many such models, all of which will have to take into account the following: Interest rates Relationship between the strike price & the asset price Maturity Volatility of the underlying asset

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Relationship Between theStrike Price & the Asset Price

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Maturity

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An increase in the maturity of an option will affect the forward prices of the underlying; these will generally rise as a function of interest rates and other cash flows associated with the assets. This will have the effect on prices noted previously. However, a greater effect will generally be the fact that a longer maturity allows prices to move more. Consequently, the possible future payoffs from an option will increase and the option value will rise. The graph below shows the effect of time to maturity on put and call prices (both are at the money with a strike price of USD 5 and volatility of 10%).

The value of both options will increase as prices have 'more time' to move and hence generate a return to the option holder. However, because forward prices will increase over time, the value of the put rises less steeply than that of the call. Volatility of the Underlying Asset 25.

The amount of fluctuation of an asset price is known as its volatility the higher the volatility, the more a vanilla option is worth. To see this, assume two underlying assets, A and B, have an underlying price of USD 100. However, the price of B changes by more, on average, than that of A. Would you rather own a USD 100 call option on asset A, or one on asset B? The potential losses on both options are the same the price might fall below USD 100, and the option would be worthless. However, the potential payoffs are greater for asset B than for asset A. Therefore, the call option on asset B will be higher.

Effect of a Rise in Volatility 26. Returning to our simple example (3-month call option strike price USD 5) we can show the effect of an increase of volatility, using our particular model, in this graph:

A rise in volatility leads to an increase in the value of our sample call option. Note that a change in volatility has no effect on intrinsic value; it only influences the potential 'optionality'. Just as time value is at its maximum for an option that is at the money, so too any price increases due to higher volatility are at their maximum for ATM options. If volatility is zero, then we simply have a payoff diagram; there is no 'optionality' because the price does not change. It is also worth noting that the increase in volatility would give additional value to this option even when the underlying market is some way from the strike price. For instance, if the underlying market is trading at USD 4.60, then a USD 5 call is almost worthless if priced using 10% volatility; however, at 30% volatility, this option is worth around USD 0.13. Intrinsic Value 27.

A 3-month call option on a fictional futures contract is struck at GBP 50. The contract is trading at a price of GBP 60. The price of the option is GBP 11. Interest rates are zero. What is the intrinsic value? GBP 11 GBP 10 Zero GBP 1 28.

Option Price Limits & Exercise Decisions

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Upper Boundary for the Price of a Call Option We can quickly establish simple maximum and minimum values for put and call options on non income-bearing assets. For a call option, whether European- or American-style, the option can never be worth more than the current asset price.

If the price of the call option was greater than the asset, then an agent could simply sell the call option, buy the stock, and invest the difference. If the call option is exercised, the agent could deliver the stock and be left with the invested money. If the call option expires worthless, then they would be left with the invested cash, plus whatever the stock was worth. In either case, a riskless profit would be obtained.

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Lower Boundary for the Price of a Call Option 31. (American) An American-style call option can never sell for less than its intrinsic value, otherwise an option could simply be bought, exercised immediately, and the asset that had been bought through the option would then be sold into the market. For example, if a USD 100 call option cost USD 7 when the underlying asset had a market price of USD 110, then by purchasing the call, exercising it immediately, and then selling the asset, a riskless profit could be obtained: Risk-less profit = (USD 110 - USD 100) - USD 7 = USD 3 The option price will naturally disallow such 'easy' money. Furthermore, we know that no option can have a negative value; at worst an option holder can simply walk away. The relationship is thus:

Lower Boundary for the Price of a Call Option (European) 32. For a European-style call option the relationship needs to be adjusted since the forward price is not equal to the spot price. To illustrate the difference, imagine two portfolios:

At expiry time T, the share is trading at a price AT. Consider portfolio 1: If K < AT, then the option will be exercised at the price K, using the money which had been previously invested. The share you have purchased is worth AT. If K > AT, then the option expires worthless, and the portfolio is simply worth the money invested, which will generate the amount K. So at time T Portfolio 1 is worth the greater of AT and K. Portfolio 2 will always be worth the future share price, AT; the value of Portfolio 1 is always higher than or equal to the value of Portfolio 2. Using the terminology above, we get:

Options cannot have a negative value; consequently the lower bound must be:

Lower Boundary for the Price of a Put Option 33. American options are straightforward, as once again the value can never be less than intrinsic value.

To illustrate the lower bound for a European option we will once again examine a pair of imaginary portfolios.

If, at time T, AT < K, then the option would be exercised. The underlying share would be delivered and an amount K would be received. The portfolio would be worth K. If, at time T, AT > K, then the option would expire worthless and the portfolio would be worth the value of the stock, that is, AT. At expiry, Portfolio 1 is worth the greater of AT and K. Portfolio 2 is only ever worth K. The value of Portfolio 1 is always higher than or equal to the value of Portfolio 2;

Options cannot have a negative value; consequently the lower bound must be:

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