Exercise value, time value, and moneyness of an option

CFA level I / Derivatives / Basics of Derivative Pricing and Valuation / Exercise value, time value, and moneyness of an option

The exercise value is the value that an option buyer will get from the option on exercising it. The exercise value is always greater than or equal to zero because if the exercise value is negative, then the option buyer will not exercise the option. The exercise value is also called as the intrinsic value of an option.

The time value of the option is simply the total value of the option minus the exercise value of the option. It should not be confused with the time value of money. However, the time to expiration plays an important role in determining the time value of the option and the other important factor for determining the time value is the volatility of the underlying. Generally, the greater is the volatility and the greater is the time to expiration; the greater is the time value of the option.

Moneyness of options: If an option has a positive exercise value, it is called as an in-the-money option. The positive exercise value for call option happens when the spot price is greater than the exercise price. For the put options, if the spot price is lesser than the exercise price, then the options will have a positive exercise value.

Similarly, if the spot price is lesser than exercise price then the call option is called as an out-of-money option and it will be opposite for the put option.

When the spot price is exactly equal to the exercise price, then the both call options and put options are called as at-the-money options.

	Spot price > Exercise price	Spot price = Exercise price	Spot price < Exercise price
Call options	In-the-money	At-the-money	Out-of-money
Put options	Out-of-money	At-the-money	In-the-money

Check your concepts:

(58.16) The price of a put option is $3.50. The underlying is trading at $75 and the exercise price is $70. What is the time value of the option?

(a) $1.50
(b) $3.50
(c) $8.50

(58.17) Which of the following options is most likely to have the highest value?

(a) In-the-money put option
(b) At-the-money put option
(c) Out-of-money put option

Solutions:

(58.16) Correct Answer is B: Intrinsic value of the put option = Max(0, 70-75) =0. Time value = Option value - Intrinsic value = 3.50 - 0 = $3.50.

(58.17) Correct Answer is A: In-the-money options are more expensive than the at-the-money options. At-the-money options are more expensive than the out-of-money options.

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