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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?

and three months to expiry. you will be able to:  explain when an option is 'in' or 'out' of the money . Interest rates for the period are 10%. On completion of this tutorial.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. OBJECTIVES 8. Question 5 of 5 Which of the following is the correct put-call parity equation? 6. and volatility is 5%. The current price of the underlying asset is EUR 75. Should the option be exercised early? Yes No 7.

    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 9. .

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Different markets have different conventions. it is best to be precise. rather than referring to an at-themoney option. In the foreign exchange market. 12. while the forward price is USD 110. because it would not make sense to exercise at USD 105 when the market price was only USD 100. 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. However. futures prices are already forward prices so 'moneyness’ is a simple . The 'moneyness' of the option can be expressed relative to the spot and the forward price. it would be better to use the terms 'at-the-money forward' or 'at-themoney spot'. while interest rate markets tend to focus on forward prices. Note that for options on futures. it is exercisable in one year’s time. The underlying price is currently USD 100.Forward Prices How do forward prices affect 'moneyness'? Consider a one-year European call option struck on widgets at USD 105. this option is not exercisable now. 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. the debate is irrelevant. Relative to the spot price This option is 'out of the money' (OTM). equity markets tend to relate option strike prices to spot prices. Rather than attempting to use different practices in different markets.

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

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. . Which of the following statements is true? The option is in the money 15. 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. Three-month interest rates are 4%.13. 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. Option Moneyness Option moneyness is summarized in the following table: 14. The current asset price is EUR 100. One-year interest rates are 5%.

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

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. The option costs EUR 5.Intrinsic Value A 3-month American call option on a hypothetical futures contract has a strike price of EUR 100. what is the intrinsic value of this option? EUR 5 -EUR 10 Zero -EUR 5 19. Assuming that interest rates are zero. The current price of a futures contract is EUR 90. 20.

Factors Affecting Option Value – An Overview It is comparatively easy to calculate the intrinsic value of an option. So how are fair prices for options obtained? Precise calculations may involve the use of a sophisticated pricing model. 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 21. There are many such models. but much harder to estimate the option's time value. or the amount a buyer is willing to pay for the possibility of future payoffs). 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. .

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Consequently. An increase in the maturity of an option will affect the forward prices of the underlying. . the possible future payoffs from an option will increase and the option value will rise. these will generally rise as a function of interest rates and other cash flows associated with the assets. However. This will have the effect on prices noted previously. a greater effect will generally be the fact that a longer maturity allows prices to move more. Maturity 24. 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%).Relationship Between theStrike Price & the Asset Price 23.

the potential payoffs are greater for asset B than for asset A. To see this. and the option would be worthless. A and B. the value of the put rises less steeply than that of the call. assume two underlying assets. However. However. or one on asset B? The potential losses on both options are the same – the price might fall below USD 100. the more a vanilla option is worth. The amount of fluctuation of an asset price is known as its volatility – the higher the volatility. . the call option on asset B will be higher.The value of both options will increase as prices have 'more time' to move and hence generate a return to the option holder. on average. Therefore. Would you rather own a USD 100 call option on asset A. the price of B changes by more. than that of A. Volatility of the Underlying Asset 25. However. have an underlying price of USD 100. because forward prices will increase over time.

Note that a change in volatility has no effect on intrinsic value. Returning to our simple example (3-month call option – strike price USD 5) we can show the effect of an increase of volatility. there is no 'optionality' because the price does not change. If volatility is zero. at 30% volatility. this option is worth around USD 0.60. 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. in this graph: A rise in volatility leads to an increase in the value of our sample call option. Intrinsic Value 27. For instance. if the underlying market is trading at USD 4. then a USD 5 call is almost worthless if priced using 10% volatility. Just as time value is at its maximum for an option that is at the money.13. however. it only influences the potential 'optionality'. so too any price increases due to higher volatility are at their maximum for ATM options. . using our particular model. then we simply have a payoff diagram.Effect of a Rise in Volatility 26.

the option can never be worth more than the current asset price. The price of the option is GBP 11. and invest the difference. If the price of the call option was greater than the asset. a riskless profit would be obtained.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. What is the intrinsic value? GBP 11 GBP 10 Zero GBP 1 28. . Interest rates are zero. then an agent could simply sell the call option.or American-style. In either case. buy the stock. If the call option expires worthless. plus whatever the stock was worth. 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. whether European. the agent could deliver the stock and be left with the invested money. If the call option is exercised. For a call option. then they would be left with the invested cash. Option Price Limits & Exercise Decisions 29.

and the asset that had been bought through the option would then be sold into the market. and then selling the asset. we know that no option can have a negative value. imagine two portfolios: . exercising it immediately. exercised immediately. To illustrate the difference. Lower Boundary for the Price of a Call Option 31.30.USD 100) . The relationship is thus: Lower Boundary for the Price of a Call Option (European) 32. a riskless profit could be obtained: Risk-less profit = (USD 110 . For a European-style call option the relationship needs to be adjusted since the forward price is not equal to the spot price. (American) An American-style call option can never sell for less than its intrinsic value. if a USD 100 call option cost USD 7 when the underlying asset had a market price of USD 110. For example. Furthermore.USD 7 = USD 3  The option price will naturally disallow such 'easy' money. then by purchasing the call. at worst an option holder can simply walk away. otherwise an option could simply be bought.

To illustrate the lower bound for a European option we will once again examine a pair of imaginary portfolios. . as once again the value can never be less than intrinsic value. Portfolio 2 will always be worth the future share price. Consider portfolio 1: • If K < AT. we get: Options cannot have a negative value. AT. then the option will be exercised at the price K. and the portfolio is simply worth the money invested. consequently the lower bound must be: Lower Boundary for the Price of a Put Option 33.At expiry time T. Using the terminology above. The share you have purchased is worth AT. American options are straightforward. then the option expires worthless. • If K > AT. the value of Portfolio 1 is always higher than or equal to the value of Portfolio 2. which will generate the amount K. So at time T Portfolio 1 is worth the greater of AT and K. the share is trading at a price AT. using the money which had been previously invested.

If. at time T. that is. Portfolio 2 is only ever worth K. 38. then the option would expire worthless and the portfolio would be worth the value of the stock. The value of Portfolio 1 is always higher than or equal to the value of Portfolio 2. 35. 39. AT. The portfolio would be worth K. The underlying share would be delivered and an amount K would be received. At expiry. then the option would be exercised. 36. 40. . consequently the lower bound must be: 34. 37.  Options cannot have a negative value. Portfolio 1 is worth the greater of AT and K. at time T. AT > K. AT < K. If.