Chapter 16, Problem 1PS

Summary Introduction

Call option:

A call option is an agreement that gives the buyer the right to buy a stock at a pre-specified price within a pre-specified period. The stock on which the call option is provided is called the underlying asset.

Intrinsic value of a call option: The intrinsic value of a call option is the value of 'S-X' where 'S' is the prevailing price of the stock and 'X' is the exercise price. So, more the price of stock, more the intrinsic value of the call option.

Time value of a call option:

The time value of a call option is the difference between the price of the call option and the intrinsic value of the call option.

To compute:

The intrinsic value of the call option and its time value

Answer to Problem 1PS

The intrinsic value of the call option is $5 and its time value is $1.50.

Explanation of Solution

The current stock price is $55 and strike or exercise price is $50.

Given:

Current stock Price= $55

Strike price = $50

Price of call option= $6.50

Calculation:

  $\begin{array}{c}Intrinsicvalue=Currentstockprice-Strikeprice\\ =\$55-\$50\\ =\$5\\ \\ Timevalue=\mathrm{Pr}iceofcalloption-Intrinsic\text{}value\\ =\$6.50-\$5\\ =\$1.50\end{array}$