What is Extrinsic Value of an Option?
Extrinsic value of the option is one of the components of the total value of the option due to time value and the impact of volatility of the underlying asset. This part of the option value does not consider intrinsic value that accounts for the difference between the spot price and exercise price of the underlying security.
Following hierarchy shows the contributors to the option value and the factors affecting these components:
- Intrinsic value is impacted by the spot price at the time of maturity, the exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. of the option, cashflows of the underlying, and the risk-free rate used for discounting
- This is affected by the time to maturity or the expiry of the option and the volatility of the underlying
Factors Affecting the Extrinsic Value
- Time value, also known as the time value of decay, represented by the options greek ‘theta’ and therefore also known as theta decay, exists because the option buyer believes that in the given time to maturity, the price of the underlying might become favourable and therefore, it is believed that longer the time to expiry, greater is the time value
- And as the time to expiry keeps on reducing, this value keeps on decaying. At the time of expiry, this value is equal to zero, and this is the reason why it is known as the time value of decay
- Volatility (option greek: ‘vega’) of the underlying has a direct relationship with the extrinsic value too because the buyer of the option buys it to hedge himself, and if he believes that the value of the underlying is not too volatile, he would never be willing to pay the price of purchasing the option.
- Therefore, if the underlying is highly volatile, the buyer can benefit from it as options have unilateral risk. That is, if the option is in the money, it will be exercised while if it is out of the moneyOut Of The Money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value., it will not be exercised. So higher the volatility of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates., the higher is the risk for hedgers, and the higher is the extrinsic value leading to higher option value.
- Having explained the factors and their relationship with the extrinsic value, we still need to understand that measuring the extrinsic value is not an easy process, and at times, there are different option values from different analysts because of their difference in opinion about the volatility measure.
Extrinsic Value Example
- As we have mentioned in the introduction, an option value has two components, intrinsic and extrinsic. When the investor purchases the option, the exercise price determined is either equal to or lower (higher) than the current spot price of the underlying for a call (put) option. This implies that the intrinsic value is 0. In the case of a call (put) option, the option has a positive payoff when the spot price at maturity is greater (lower) than the exercise price.
- Even with a 0 intrinsic value, the investor pays the premium to purchase the option. So at this time, the entire premium is due to the extrinsic value.
- For example, if the exercise price for a call option is $100, and the Spot price of the underlying is either $100 or less, the payoff is 0. Let’s suppose, during the time of the option, and the spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery. becomes 110, then the payoff is 110-100 = $10 and lets us say there are three months to expiry, we feel that the underlying can go up to $120, so the option price will be higher than the current payoff of 10, maybe $15, this addition $5 is due to extrinsic value, more precisely time value if volatility is constant.
Option Pricing Methods
Based on the lengths of the interim time periods from the time of purchase of the option till the time of maturity, there are two popular methods used for option pricing, the binomial method when the time periods are discrete such as two years, and the BSM method and its variants such as the Black method, when the desired pricing is continuous.
The price arrived at any of these methods encompasses both the intrinsic and extrinsic value of the option. If the market price is even higher than this price, then there can be two reasons for this:
- Either there is an arbitrageAn ArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security's price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left. opportunity.
- Or the estimates of volatility are amiss. At times we back-calculate the volatility from the current market price op the option, and such volatility is known as the implied volatility, whereas there is another method for volatility calculation known as the historical method.
Assumptions of the Black Scholes Model
We need to also look at a few assumptions of the BSM because some of these are very simplistic as compared to a real-world scenario:
- We assume that the volatility of the underlying is known and constant
- The risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk. is known and constant
- The underlying has no cash flows
- There are no transaction cost or taxes
However, these assumptions do not always hold true in the real world, and therefore the BSM model requires adjustments to be made to incorporate such variance. Such adjustments vary from analyst to analyst, and therefore there might be a possibility that the price calculated from these methods may vary from the current market price.
What we need to understand from this is that it is not always the case that the market price – intrinsic value = extrinsic value, and here is the difference between the terms price and value of the option. Price may refer to the market price, and the value may refer to the calculated price from one of these models, and premium may refer to the amount paid at the time of the purchase of the option.
The formula for BSM for calculation of a call option price is below for understanding:
- Without going in too much depth, we only should understand the points from the perspective of this article.
- The standard deviation is the symbol for volatility, and the T-t is the time till expiry. Therefore the formula suggests that the price calculated using this model incorporates for extrinsic value variables along with intrinsic value variables.
- We understand that the extrinsic value of the option is one of the components of the total value of the option, existing due to time value and the impact of volatility of the underlying asset.
- Calculation of extrinsic value may not always be easy because of the variation in calculation of the volatility input of the option pricing methodology. However, if we use the market price of the option to back-calculate the volatility, such volatility is known as the implied volatilityImplied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model..
- Implied volatility can only be calculated only if we know the market price and therefore, can’t be predicted with accuracy, making the predictability of extrinsic value extremely difficult.
This has been a guide to What is Extrinsic Value & its Definition. Here we discuss the components of extrinsic value and its factors along with examples. You can learn more about from the following articles –