Investments

Two possible prices, one fair option value

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Copy option payoffs with shares and borrowing, then work backwards through a tree to price calls and puts. Solve has 10 questions on replication, arbitrage and early exercise.

Value before expiry · Step 1 of 12

An option has exercise value and value from waiting

Intrinsic valueTime value

Value before expiry · Step 1 of 12

An option has exercise value and value from waiting

We follow fictional Velvetcog Works, whose share is $50.00, with a $50.00 exercise price. Intrinsic value is the cash value of exercising now; time value is the option quote minus intrinsic value. Here the American option quote is built as intrinsic value plus the time value you choose.

Try it: Move the share price through the exercise price, then remove the time value.

Option

Share price today ($)50

Time value per share ($)6

Option quote

$6.00

Intrinsic

$0.00

Time value

$6.00

The tree examples assume no dividends, taxes or trading costs, fractional shares, and borrowing and lending at the same risk-free rate. Each move in the first trees lasts one year; the last lesson makes the steps shorter.

Intrinsic = max(S − X, 0).

max((50 − 50), 0) = $0.00.

Quote = (0 + 6) = $6.00.

Time value = (6 − 0) = $6.00. At the money.

Check yourself

A call quote is $9, with a share price of $55 and a $50 exercise price. Its time value is…

Exam coming up and the tree only makes sense going forwards?

Bring your problem sets. We work through them together until every type feels routine.

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Two possible prices, one fair option value

An option has exercise value and value from waiting

An option has exercise value and value from waiting

Read intrinsic value and time value from quotes

Exam coming up and the tree only makes sense going forwards?

Questions, answered.

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