Types of Derivatives-Cont’d Options-Cont’d Components of the Option Price-Cont’d
Time premium of an option,
or time value of the option, is the amount by which the option’s market price exceeds its intrinsic value. It is the expectation of the option buyer that at sometime before the expiration date the changes in the market price of the underlying asset will increase the value of the rights of the option. Because of this expectation, the option buyer is willing to pay a premium above the intrinsic value. An option buyer has two ways to realize the value of an option position. The first way is by exercising the option. The second way is to sell the option in the market.
Types of Derivatives-Cont’d Options-Cont’d Put-Call Parity Relationship Fora European put and a European call option on the same underlying (that pays no income,
strike price, and expiration date, there is a relationship between
the price of a call option, the price of a put option,
the price of the underlying, and the strike price. This relationship is known as the
put-call parity relationship. The relationship is thus Put option price − Call option price = Present value of strike price − Price of underlying asset. The put-call parity relationship can be used to create synthetic options, bonds, and stocks.
