Corporate Finance

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Corporate Finance

Payoff Price of the underlying asset

Like call options, the payoff for the put option holder and writer sum to zero.

DETERMINANTS OF OPTION VALUE

Note from the data on option prices of ACC stock that the market value of the option is more than the
intrinsic value. That is, the market value of the call option on March 20 was Rs 5.15, whereas the intrinsic
value was Rs 4 (i.e., Rs 139–Rs 135). Likewise, the put option was worthless (i.e., out of the money). Yet it
has value: –Rs 2.70. This is true of all options that have time remaining to maturity. Exhibit 12.1(a) is a graph
of a call option’s premium relative to intrinsic value.

Exhibit 12.1(a) Call option premium relative to intrinsic value

Intrinsic value

Premium value

Price of underlying asset

Exercise price

Call option price

K

How much the premium exceeds the intrinsic value depends on six factors:

• Underlying asset price,


• Exercise price,


• Risk free rate,


• Volatility of the asset price,


• Time to expiration, and


• Cash distributions from the underlying asset (i.e., dividends in case of stock).

Asset Price

For an American or European call option, an increase in the asset price leads to an increase in the option’s
intrinsic value because the option becomes more valuable. The premium, therefore, increases with an increase