An Option is
said to be in-the-money when the underlying exchange rate is superior to
the exercise price (in the case of call Option) and inferior to the exercise
price (in case of put Option).
Likewise, it is said to be out-of-the-money when the underlying
exchange rate is inferior to the exercise price (in case of call Option) and
superior to exercise price (in case of put option).
Similarly, it is at-the-money when
the exchange rate is equal to the exercise price.
For example, an American type call Option that enables purchase
of US dollar at the rate of Rs 42.50 (exercise price) while the spot exchange
rate on the market is Rs 43.00 is in-the-money. If the US dollar on the spot
market is at the rate of Rs 42.50, then the call Option is at-the-money.
Further, if the US dollar in the Spot market is at the rate of Rs 42.00, it is
obviously out-of-the-money.
It is evident that an Option-in-the-money will have higher premium
than the one out-of-the-money, as it enables to make a profit.
Time Value
Time value or
extrinsic value of Options is equal to the difference between the price or
premium of Option and its intrinsic value. Equation defines this value.
Time value
of Option = Premium - Intrinsic value
Suppose a call option enables
purchase of a dollar for Rs 42.00 while it is quoted at Rs 42.60 in the market,
and the premium paid for the call option is Re 1.00, then,
Intrinsic value
of the option = Rs 42.60 - Rs 42.00 = Re 0.60
Time value of
the option = Re 1.00 - (42.60 - 42.00) = Re 0.40
Following
factors affect the time value of an Option:
o
Period that remains
before the maturity date: As the Option approaches the date of expiration,
its time value diminishes. This is logical, since the period during which the
Option is likely to be used is shorter. On the date of expiration, the Option
has no time value and has only intrinsic value (that is, premium equals
intrinsic value).
o
Differential of
interest rates of currencies for the period corresponding to the maturity date
of the Option: Higher interest rate of domestic currency means a
lower PV (present value) of the exercise price. So higher interest rate of
domestic currency has the same effect as lower exercise price. Thus higher
domestic interest rate increases the value of a call, making it more attractive
and decreases the value of put. On the other hand, higher interest rate on
foreign currency makes holding of the foreign currency more attractive since
the interest income on foreign currency deposit increases. This would have the
effect of reducing the value of a call and increasing the value of put.
o
Volatility of the
exchange rate of underlying (foreign) currency: Greater the volatility greater is the probability of exercise of
the Option and hence higher will be the premium. Greater volatility increases
the probability of the spot rate going above exercise price for call or going
below exercise price for put. So price is going to be higher for greater
volatility.
o
Type of Option: American Option
will be typically more valuable than European Option because American type
gives greater flexibility of use whereas the European type is exercised only on
maturity.
o Forward discount or premium: More a currency
is likely to decline or greater is forward discount on it, higher will be the
value of put Option on it. Likewise, when a currency is likely to harden
(greater forward premium), call on it will have higher value.
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