One for the real pedants amongst us – but one that is important for hedge accounting with options under IAS 39 (AASB 139). FAS 133 has answered this one through DIG E19, but IAS 39 has an important difference.
Theory
How is the value of an option correctly split between the time component and the intrinsic component? Essentially, from my point of view there are actually three components of the value of an option:
- What I will call the current intrinsic value – i.e. the difference between the current spot price of the underlying and the strike price of the option;
- The value that stems from the volatility over time of the underlying; and
- The difference between the value in (1) and the forward value of the underlying.
In the context of IAS 39 para 74, the question of whether element (3) is considered to be intrinsic or time value may become important – the precise reason is not important, but, if you really want to know it, feel free to ask in comments.
Question
I am aware of at least three definitions of intrinsic value sometimes used in the market – they are:
- The difference between the current spot price of the underlying and the strike price of the option;
- The present value of the difference between the strike price and the forward price of the underlying;
- The difference between the strike price and the undiscounted forward price of the underlying.
Which of these do you consider the most common and / or correct and why?
5 comments
14 May, 2007 at 20:22
Andrew
I should add that my personal opinion is view 1, but another guy whose opinion I respect says view 2, so the question must be open to reasoned argument.
The reason I say view 1 is correct is that, to me at least, time value is value arising from any time component.
18 May, 2007 at 13:14
Steve Edney
Andrew,
I don’t think that there is a clear answer. Most simply the answer is 1, the value were the option excercise imediately. This is how Hull defines it, at least in my version which is a couple of versions old.
However it is not uncommon to consider “at-the money” to be when the forward price is at the strike, which via put call parity is when a call and put at the same strike and maturity are of equal value. This sort of implies “3”. either way I don’t think you present value the amount. Surely its not a real value but the notional payoff. Or under definition 3 the payoff at the expected future spot value.
Of course how accountants decide to split things up is a constant mystery to us quants.
18 May, 2007 at 13:29
Andrew
Thanks for that Steve. Do you think there might be a difference if the option is European as opposed to an American option?
On the accountants point – I would tend to agree. Floating, as I do, between the accounting world and the quant world can make the issue (or just me) really confused at times. Where the standards makes little sense, or appears confused as IAS 39 does here, it does not help.
The Hull definition is used in the context of employee share options, but, helpfully, that definition was not repeated in the context of financial instruments – thus the current question.
18 May, 2007 at 14:06
Steve Edney
Would be strange if they had differnent intrinsics, as they have the same value for vanilla calls.
When I say intrinsic I am usually refering to your definition “1”, and that is what I would expect people to mean when they use the term. I don’t know if I can help you with the accounting definitions.
18 May, 2007 at 14:20
Andrew
I have seen some strange outcomes from accounting standards.
Thanks for the feedback on the intrinsics. 1 is the definition I used to use but I have not been front office for about 7 years so things could have changed.
I think this is just someone trying to torture the standards to come up with a definition that suits them.
More generally – personally I prefer using (bought) options as hedging instruments. Forwards I see as riskier if the hedged item is less than certain. The pity is that the accounting standards make a meal of them.