Answered: A friend of yours tells you she holds…

A friend of yours tells you she holds an American call option that is very deep- in-the-money. She tells you she’s going to exercise it now and cash in on her winnings. Is this a wise move to make?

International Financial Management

14th Edition

ISBN:9780357130698

Author:Madura

Publisher:Madura

Chapter5: Currency Derivatives

Section: Chapter Questions

Problem 1CT

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Question

Q. A friend of yours tells you she holds an American call option that is very deep-
in-the-money. She tells you she’s going to exercise it now and cash in on her
winnings. Is this a wise move to make?

- The answer to this question is given below but I don't understand the explanation, please clearly explain in simple terms.

No, she should sell it. Sell now you get intrinsic value PLUS time value,
rather than exercise now which leads to just S-X.

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How can she earn the time premium? I am very confused. How can she sell it without buying first?

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