I am a French speaker and have been following Analystforum for the past 2 months and would first like to take advantage of this post to thank you all very much. I seat for the level 1 this Saturday.
Can you please give me further explanations regarding the questions below ? I am missing easy points on option valuation in derivatives… Shouldn’t the value of an option at expiration equals: (1) its payoff if in-the-money or (2) zero if out-of-money? Considering a put, you should exercise your right if X < S ? Meaning its value is positive? (and the opposite for a call) Plz clarify
Thank you and good luck to all the CFA level 1 candidates !
1. If the exercise price of a European put option at expiration is below the price of the underlying, the value of the option is most likely:
X greater than zero.
less than zero.
equal to zero.
Incorrect.
If the exercise price of a European put option is below the underlying price at expiration, the option is worthless and has a value of zero.
CFA Level I
“Basics of Derivative Pricing and Valuation,” Don M. Chance
Section 4.1.1
2. Exercise of a European put option is most likely justified if:
the option is out-of-the-money.
the exercise price exceeds the value of the underlying.
X the exercise value is negative.
_ Incorrect. _
If the exercise price exceeds the value of the underlying at expiration, the option has positive exercise value and may be exercised.
CFA Level I
“Basics of Derivative Pricing and Valuation,” Don M. Chance
Hi, French buddy! When we are talking about the option value, there’s actually 2 things: time value and intrinsic value.
When expiration day comes, time value of any option, regardless it’s in the money of out of the money, all become 0. In another word, as time goes by, time value of option decreases everyday till 0.
Intrinsic value is decided by the difference between strike price and the present underlying asset price. If positive, intrinsic value = the difference; if negative, intrinsic value= zero.
First question you posted: Since its at the expiration day, time value of the option = 0 . And strike of your put < underlying price, your option is out of the money, intrinsic value = 0 as well. Remember, buy put @ strike =1 means you agree to sell the underlying at the price of 1.
This is what I thought too but the answer is actually: "spot price of the underlying minus forward price agreed in the contract ". It makes more sense if you consider for instance F= $10 and S= $5: You have lost $5, which comes to S-F.
The question is on the value of the derivative. You wouldn’t want to hold this (long) contract as it has a value of (5), or Spot -/- Forward, i.e it has a negative **value** to the long. Alternatively, the value to the short is a positive 5.
The amount the long will need to pay the short at expiration is indeed $ 5 .
