THE OPTION PREMIUM

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THE OPTION PREMIUM

• Associated with any option is a premium. This
  premium, or value of the option is composed of 2
  parts
• INTRINSIC VALUE The intrinsic value (IV) of the
  premium is the value of the premium associated
  with exercising the option, given the current
  spot rate.
• TIME VALUE The time value (TV) of the option
  reflects the likelihood that the spot rate will
  change in the future and the option will have
  even greater intrinsic value.

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• Example Suppose the British Pound is currently
  trading at 1.65. Suppose too an American Style
  Call Option with a strike price of 1.615 is
  currently offered at a premium of .04.
• The call has IV of 1.65 - 1.615 .035.
• The call has TV of .005 (premium - IV)

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Observations on the IV

• Call Option
• If strike price lt spot rate, IV spot - strike
  price
• If strike price gt spot rate, IV 0.
• Put Option
• If strike price gt spot rate, IV strike price
  - spot
• If strike price lt spot rate, IV 0.

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Some Pictures ...The Call ...
Value of Call Option (the premium)

Time Value (for the 6 month option)
6 month
Intrinsic Value (E S)
3 month
S (Strike Price)
E (Spot Rate)
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• Notice 2 things hereThe Intrinsic Value 0
  for spot rates less than S, the strike
  price.The top dotted line represents the value
  of an option that expires in 6 months, the bottom
  dotted line represents the value of an option
  expiring in 3 months...
• The Premium is greater the longer the time
• from the expiration date.

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The Put ...

Value of Put Option
Time Value (for the 6 month option)
Intrinsic Value (S E)
6 month
3 month
S (Strike Price)
E (Spot Rate)
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Problem 1 Priority Eyeware imports eyeware, must
pay 125 Million Yen in 3 Months

• Alternatives ...
• Can buy 20 Yen Call Options (Each contract
  6.25 Million Yen and 20 x 6.25 M 125 Million).
• Strike Price .00800 per Yen
• Premium 0.00015 per Yen.
• Current Spot Rate .007823.
• CEO believes that in 90 Days
• Most Likely Value for the Yen 0.007900
• High Value for the Yen 0.008400
• Low Value for the Yen 0.007500

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• A Couple of Things to Note
• --- The Option is initially "Out of the Money".
• --- We have a Call Option and Strike Price gt
  Spot Rate. This means that initially, the value
  of this option reflects Time Value only
  (Intrinsic Value 0).
• --- At its Low and its Most Likely Value, the
  option is Out of the Money, but it is In the
  Money at the High Value.
• --- The Premium must be paid regardless of
  whether or not the option is excercised in the
  future.

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• Questions
• A. Compute Priority's gains and losses on the
  call option position for the given range of
  expected spot prices. Draw a picture of the
  gains/losses on the call option.
• B. What do the gains/losses look like for the
  person taking the other side of this contract?

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Answer to A

• Anticipated Loss
• The worst anticipated outcome in this case
  occurs if the spot price in 90 days is less than
  the strike price. In this instance, the holder
  of the call option would forgo the option and
  purchase the Yen on the spot market. This
  represents a floor for the losses
• Premium x ( of Yen) 0.00015 (125 M) 18750
• Break-Even Point
• A holder of a call option will exercise the
  option whenever the strike price lt spot rate. It
  does not ensure that the holder gains by holding
  the option. That only occurs, in the case of a
  call option, when the spot rate has risen high
  enough so that the holder gains enough to cover
  the premium
• Spot Rate - Strike Price - Premium 0
• Spot Rate .008 0.00015 .00815
  per Yen.

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• Greatest Anticipated Gain
• In this case, the greatest anticipated gain
  occurs when the spot rate reaches its highest
  anticipated value.
• (Highest Anticipated Spot Rate - Strike Price -
  Premium) Yen
• (0.008400 - .008 - .00015) 125 Million 31250

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READING OPTION QUOTES(Example)

• German Mark 125,000 marks, cents per mark
• Option Strike ------ Call ------
  ------Put ------
• Underlying Price Oct Dec Mar Oct
  Dec Mar 56.20 55.5 1.19
  1.70 s 0.17 0.69 s
• 56.20 56.0 0.83 1.38 2.06
  0.31 0.87 1.24
• 56.20 56.5 0.53 1.13 s
  0.51 1.11 s
• 56.20 57.0 0.32 0.90 1.57
  0.80 1.37 1.73
• 56.20 57.5 0.19 0.70 s
  1.35 1.67 s
• The option underlying refers to the current
  spot rate of the mark in terms of US cents. The
  figures under the Call Oct' column are the
  premiums associated with each option strike price
  if the Call is exercised in Oct. For example, a
  Call option with a strike price of .57 and a
  maturity date in October has a premium of .0032
  per mark.