Assume we have a stock currently worth $100. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $5 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option?
A) $10
B) $5
C) $0
D) None of the answers is correct.

Question

Quizplus · Accepted Answer

The time value of an option is the extra amount an investor is willing to pay over its intrinsic value, due to the possibility that the stock price might move in a favorable direction before the option expires. In this scenario, since the stock can either rise or fall by $5, the expected value of the option at expiration is a gain of $5 if the stock rises (since it would be in the money by $5) and $0 if the stock falls (since it would be out of the money and thus worthless). The average of these two outcomes is $2.50, not accounting for any interest rate or discounting since it's assumed to be zero. Since none of the provided options accurately reflect this calculation, the correct choice is that none of the answers is correct.

Assume We Have a Stock Currently Worth $100