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.
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.
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?