Pricing and Valuation of Options

How an option's price splits into exercise value and time value, what moneyness tells you, why no-arbitrage sets upper and lower bounds on European call and put prices, how replicating an option differs from replicating a forward, and how the underlying price, exercise price, time, interest rate, volatility and carry benefits or costs push option values up or down.

1. 1. Payoff at expiration and exercise value before itBefore expiration, an option's exercise value is what it would be worth if you could settle it now, comparing the spot price with the present value of the exercise price.Free12 min
2. 2. Moneyness: in, at and out of the moneyMoneyness compares the underlying price with the exercise price; it tells you how likely exercise is and how strongly the option's price reacts to the underlying.10 min
3. 3. Time value and time value decayAn option's price is its exercise value plus its time value, the extra a buyer pays for the chance that the underlying moves favourably before expiration.11 min
4. 4. Arbitrage: forwards versus options, and option price boundsA forward's symmetric payoff pins down one no-arbitrage price, but an option's one-sided payoff only lets arbitrage fix a range: a lower bound and an upper bound.Video · 6 min13 min
5. 5. Replication: forwards versus optionsLike a forward, an option can be copied with the underlying and risk-free borrowing or lending, but because exercise is uncertain, the copy uses only part of PV(X) and must be adjusted over time.11 min
6. 6. Factors that determine an option's valueSix factors drive option value; volatility and time usually push calls and puts the same way, while the underlying price, exercise price, interest rate and carry benefits or costs push them in opposite directions.Video · 6 min14 min