Chapter 03 · Section 3.1

Pricing summary

We can summarize the pricing of an option as follows:

PREMIUM (OR OPTION PRICE)= INTRINSIC VALUE + TIME VALUE
Where the Intrinsic Value:

• For a call option: price of the underlying less the exercise price.
• For a put option: exercise price less the price of the underlying

• Time to maturity
• Interest rate
• Volatily of the underlying asset

Do you think the time value can be negative?

a) no
• b) yes
  No. As long as we are talking about an American style option (exercisable at any time before expiration), time value is never negative: if it were, one could buy the option below its intrinsic value, exercise it and make a instant risk-free profit.

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