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FRM Part I · FRM Exam Part I · Options Markets

Which statement about an option's intrinsic value and time value is correct for a European-style call option that is currently out of the money with three months to expiry?

An out-of-the-money call has zero intrinsic value, since intrinsic value is the greater of spot minus strike and zero. Its positive premium therefore consists entirely of time value, reflecting the chance of finishing in the money. European style does not remove time value.

  1. AIntrinsic value is zero and the premium consists entirely of time valueCorrect
  2. BIntrinsic value equals the premium and time value is zero
  3. CIntrinsic value is negative, equal to spot minus strike
  4. DTime value is zero because the option cannot be exercised before expiry

Explanation

Intrinsic value is max(S-K,0), which is zero when the call is out of the money, so the premium, which is positive, is all time value. Intrinsic value is never negative. European options still carry time value before expiry because the price may move favourably.

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