In this article, you will learn everything about the intrinsic value in the context of finance and options. But first, let’s start with the origin of this term.
The Meaning of Intrinsic
Before going into the details regarding the intrinsic value of an option, let’s look up the general meaning of the word intrinsic. According to the Cambridge Dictionary, a description for this word is “being an extremely important or basic characteristic of a thing.” Or we can say, something intrinsic is essential and necessary.
What is the Intrinsic Value?
Intrinsic value is a fundamental characteristic in many fields such as philosophy or finance. As a very general definition, we can say that it’s the value that a thing has “in itself.”
The intrinsic value of an option is the In-The-Money part of the option’s price. In other words: It is the portion of the price which you can’t lose until the expiry date just due to the progress of time if the value of the underlying doesn’t move anymore. The reason is the following: At the end of the option’s lifetime, the time value is 0. The option only consists of intrinsic value at its expiry.
Referring to the general meaning of intrinsic value, we can say the following: The value which an option has in itself is precisely the value that it would have at the time of its expiration. The rest of the option price is time value. It’s an extra value which results from the probability of further gains before the option expiry – based on statistical assumptions and pricing models.
Intrinsic Value of Call Options and Put Options
An fx option contract has intrinsic value when it is In-The-Money. We remember that with Call options, we bet that the price of the underlying asset will rise in the future. On the other hand, Put options are bets that the underlying fx rate will drop in the future. For a Call option, the price has intrinsic value when the underlying fx rate is higher than the strike price. Likewise, a Put option contract has intrinsic value if the price of the fx rate is lower than the strike price.
Calculating the Intrinsic Value of Fx Options
- The intrinsic value of an fx call option is the difference of the underlying spot rate and the strike price of the option.
- The intrinsic value of an fx put option is the difference of the strike price of the option and the underlying spot rate.
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Let’s have a look at an easy, illustrative example. If the EUR/USD is trading at $1.25, then our fx Call option has intrinsic value if and only if the strike price is below $1.25. For instance, our call option has $0.02 of intrinsic value if the strike is $1.23.
Easy, isn’t it? Sometimes, financial concepts and terms are more straightforward than they seem. After reading this article, we know all the essential things about one important component of options.
Now we understand the meaning of intrinsic value and know how we can calculate it. As for the other important determinant, the time value, it’s much more complicated. We will examine different pricing models for estimating the time value in other articles.