Chapter 12 Question 12.5

[Sunil Chaudhary]

Hi,

Regarding question 12.5 and graph 3, as per my understanding when the interest rate is zero, the value of call option should be max{S-K,0} which is zero in this case. However this is not what the explanation says.

It appears that I am missing something.

Can someone please explain.

Thanks
Sunil

 

[Alvin Kissoon]

Hi Sunil,

You are referring to the intrinsic value, not the value of the call option. If the call option was exercised today, the value would be zero (this is the intrinsic value). However, the value of the call option is comprised of two parts, the intrinsic value + the time value.

The time value is value from being able to wait for the option. In other words, in the time period between now until expiry, the stock price could increase to greater than the strike price, and so the intrinsic value would become positive for the call option.

Therefore, the value of the call option is positive.

I hope this helps, please let me know if you have any followups.

Alvin.

 

[Sunil Chaudhary]

Hi Sunil,

You are referring to the intrinsic value, not the value of the call option. If the call option was exercised today, the value would be zero (this is the intrinsic value). However, the value of the call option is comprised of two parts, the intrinsic value + the time value.

The time value is value from being able to wait for the option. In other words, in the time period between now until expiry, the stock price could increase to greater than the strike price, and so the intrinsic value would become positive for the call option.

Therefore, the value of the call option is positive.

I hope this helps, please let me know if you have any followups.

Alvin.

Thanks Alvin.