Intrinsic value

Definition

Intrinsic value refers to the actual, inherent worth of an asset or financial instrument, regardless of its market price. In the context of financial derivatives and option pricing, intrinsic value represents the difference between the underlying asset's current price and the strike price of the option when the option is in-the-money. This concept is crucial for understanding how options are valued and how they behave in various market conditions.

5 Must Know Facts For Your Next Test

1. Intrinsic value only applies when an option is in-the-money; for call options, it’s calculated as the underlying asset's current price minus the strike price.
2. An option's intrinsic value cannot be negative; if an option is out-of-the-money, its intrinsic value is considered zero.
3. Understanding intrinsic value helps traders assess whether an option is worth exercising or holding based on its current market situation.
4. Intrinsic value is a key component in determining the total premium of an option, which also includes extrinsic value.
5. Market conditions and changes in the underlying asset's price can significantly affect the intrinsic value of options over time.

Review Questions

• How does intrinsic value affect the decision-making process for traders dealing with options?
  • Intrinsic value plays a crucial role in traders' decisions as it helps them determine whether to exercise an option or not. If an option has positive intrinsic value, it indicates that exercising it could lead to a profit based on current market prices. Conversely, if an option is out-of-the-money with zero intrinsic value, traders might choose not to exercise it, potentially allowing them to look for better opportunities elsewhere.
• Compare and contrast intrinsic value and extrinsic value in the context of options pricing.
  • Intrinsic value represents the actual worth of an option based on its current relationship to the underlying asset's price, while extrinsic value accounts for additional factors such as time until expiration and market volatility. Intrinsic value focuses solely on whether an option is in-the-money or not, whereas extrinsic value can vary widely even when intrinsic values remain constant. Together, these values make up the total premium of an option, guiding traders' strategies.
• Evaluate how changes in the underlying asset's price influence both intrinsic and extrinsic values of options over time.
  • As the underlying asset's price fluctuates, intrinsic value can change significantly, especially when approaching or surpassing the strike price. An increase in the asset's price boosts intrinsic value for call options and decreases it for put options. Extrinsic value may also be impacted by these changes since increased volatility or time decay can alter perceptions of future potential returns. Thus, both values are interrelated and together shape options trading strategies in response to market dynamics.

Related terms

Extrinsic Value: The portion of an option's price that exceeds its intrinsic value, often attributed to time value and market volatility.

Strike Price: The predetermined price at which an option can be exercised, determining whether an option is in-the-money or out-of-the-money.

In-the-Money: A term describing an option that has positive intrinsic value; for call options, this means the underlying asset's price is above the strike price, while for put options, it means the price is below the strike price.