Assume we have a stock currently worth $50. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $50. If the stock can rise or fall by $10 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) $5
B) $10
C) $50
D) $40

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 expiration. In this scenario, if the stock rises to $60, the option has an intrinsic value of $10. If it falls to $40, the option has no intrinsic value (as it would not be exercised). Given the equal probability of rising or falling, the expected value is the average of the two outcomes: $10 (if it rises) and $0 (if it falls), which is $5. This represents the time value of the option, as there is no intrinsic value at the start (since the strike price equals the stock price).

Assume We Have a Stock Currently Worth $50