Question

a) What are the five factors that determine an option’s value.

b) What is the effect of an increase in the stock price on the value of a call option. What is the effect of increase in the time to expiration on the option on the value of a call option? Give an intuitive explanation of your answer.

Answer 1

a) Five factors that determine an option’s value:

1. The price of the underlying asset (stock, commodity etc)

2. Exercise price or strike price which is the predermined price at which the asset might be bought or sold by the option holder upon maturity. The option holder has a right to exercise the option, he doesn't have any obligation to do so.

3. Volatality, i.e, price movements of the asset over a given period of time.

4. Interest Rates, opeion prices are affected by changing interest rates

5. Time to expiration, i.e, the time remaining till the option matures

b) Call options tend to be 'in the money' when the stock price rises above the exercise price, hence the more the stock price will rise, the higher will be the value of the call option.

For the option buyer, the value of the option will decrease as the time to expiration approaches, since if days keep passing without much change in the price of the underlying stock, then the option value falls.

Conversely, for the option seller, the value of the option will increase as the time to expiration approaches.