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19 Option Valuation - Basics of Option Valuation 1 Comm367...

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Comm367 1 Basics of Option Valuation
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Comm367 2 Intrinsic Value u Intrinsic value is the value realized from immediate exercise Call options: maximum (ST-X, 0) Put options: maximum (X-ST, 0) u Prior to option maturity, option premiums exceed intrinsic value Time Value = Option Price - Intrinsic Value
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Comm367 3 Time Value of Call Options Option value Stock Price Value of Call Intrinsic Value Time value X S
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Comm367 4 Factors That Determine Option Values u The time to expiration has impact only on American options. u The expected return on the underlying asset does not have a direct impact on the value of Variable Increases Call Put Share price (S) Up Down Exercise price (X) Down Up Volatility ( σ ) Up Up Time to expiration (T) Up Up Risk-free rate (r) Up Down
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Comm367 5 Option Price Boundaries u At maturity, option prices are equal to their intrinsic values u Intrinsic value provides the lower bound prior to maturity u Maximum option prices prior to maturity Call options: price of stock, S0 Put options: exercise price, X
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Comm367 6 Allowable Range for Call Call Value S0 PV (X) + PV (D) Upper bound = S0 Lower Bound = S0 - PV (X) - PV (D)
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Comm367 7 Figure 19.3 Call Option Value as a
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Comm367 8 Early Exercise of American Options u It is never optimal to exercise American call options on non-dividend paying stocks early, assuming we want to keep the stock after exercising the call No income is sacrificed. We delay paying the strike price. Holding the call provides insurance against stock price falling below strike price.
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