Dan bought an option “May 100 P H”. On 20.4.07 the price of the option in the market (the premium) was $20K. The price of the house on the open market was $90K.

1. What is the internal value of the option on that date? What is the time value?

2. In the option in the money, on the money or outside the money?

3. Assuming that the price of the house stays at $90K on 25.5.07, how in your opinion, will the premium change on that date?

4. At the end of May the market price of the house is still $90K. What is the time value at expiry? And what is the premium?

Solution

1. This is a Put option. Thus the internal value of the option is the exercise price less the market price. The internal value of the option is $10K (= 100K – 90K).

The time value is the premium less the internal value, and thus the time value is $10K (=20K-10K).

2. If it were possible to exercise the option on 20.4.07, it would be worth doing so. Thus the option is in the money (positive time value).

3. The internal value of the option remains $10K, since the price of the house has not changed. However, the time remaining is shorter until the expiry of the option. We would therefore expect the time value to fall below $10K, and thus the premium on the option will be less than $20K.

4. At expiry, the option has the same value as its internal value. In other words the premium at expiry is $10K. The time value at expiry is $0, since no time remains.