Question

In: Finance

1- The time value of an option increases as a) The maturity approaches. b) The option...

1- The time value of an option increases as

a) The maturity approaches.

b) The option goes deeply ITM (In The Money).

c) The option goes deeply OTM (Out of The Money).

d) The option is ATM (At the Money).

e) Others.

2- If the observed futures price is less than the theoretical futures price, the profitable arbitrage strategy to be applied is

a) A cash and carry strategy

b) A reverse cash and carry strategy

Expert Solution

1. D) is the correct answer.

Explanation:

Options Premium (P) = Intrinsic Value (IV) + Time Value (TV)

Thus, TV = P - IV

IV (In case of Call Options) = Market price of spot - Strike Price

The time value of money decreases as the maturity approaches (time decay).

The time value of money also decreases deeper you go OTM (as IV in case of OTM is zero, and premium decreases, so premium decreases only because of decrease in time value.

The time value of money decreases deeper you go ITM (though the premium increases due to increase in the intrinsic value, formula is given above).

The time value of money is maximum at ATM, because the potential for intrinsic value to increase is greatest at this point.

2. It depends if the observed future price is less than or more than the spot price.

If the observed future price is more than the spot price, it is a Cash and carry Arbitrage strategy. Else, it is a reverse cash and carry Arbitrage strategy.

jeff jeffy answered 1 year ago

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