PAPER – 2 : MANAGEMENT ACCOUNTING AND FINANCIAL ANALYSIS 39 +
FINAL EXAMINATION : NOVEMBER, 2004 40is defined as the difference between the option’s strike price (X) and the stock’s actual current price (CP). In the case of a call option, you can calculate this intrinsic value by taking CP – X. If the result is greater than zero (in other words, if the stock’s current price is greater than the option’s strike price), then the amount left over after subtracting CP – X is the option’s intrinsic value. If the strike price is greater than the current stock price, then the intrinsic value of the option is zero – it would not be worth anything if it were to be exercised today (please note that an option’s intrinsic value can never be below zero. To determine the intrinsic value of a put option, simply reverse the calculation to X – CP. To illustrate, let us assume Wipro stock is priced at Rs. 105. In this case, a Wipro 100 call option would have an intrinsic value of (Rs. 105 – Rs. 100 = Rs 5). However, a Wipro 100 put option would have an intrinsic value of zero (Rs. 100 – Rs. 105 = Rs. –5). Since this figure is less than zero, the intrinsic value is zero. Again, intrinsic value can never be negative). On the other hand, if we were to look at a Wipro putoption with a strike price of 120, then this particular option would have an intrinsic value of Rs. 15 (Rs. 120 – Rs. 105 = Rs. 15). Time Value:This is the second component of an option’s price. It is defined as any value of an option other than its intrinsic value. Looking at the example above, if Wipro is trading at Rs. 105 and the Wipro 100
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