Financial Accounting and Reporting-CPA Practice Exam

What does the formula for the fair value of an option include?

1. Market Value + Exercise Price

2. Intrinsic Value + Market Value

3. Time Value + (Market Value - Exercise Price)

4. Time Value + Intrinsic Value

The correct answer is: Time Value + (Market Value - Exercise Price)

The formula for the fair value of an option is indeed based on the concept of combining time value and intrinsic value. The fair value of an option reflects both the immediate value it provides if exercised right now and the potential value if held until expiration, considering factors like time until expiration and volatility. Intrinsic value is calculated as the difference between the current market price of the underlying asset and the exercise price of the option when it is in-the-money (when exercising it now would yield a profit). If the market price is lower than the exercise price, the intrinsic value is zero. Time value accounts for the uncertainty associated with the time remaining until the option's expiration. It represents the possibility that the market value of the asset could move favorably before the option expires, potentially increasing its value. By combining time value with intrinsic value, you get a complete picture of the option's fair value. This approach captures both the immediate value that would be realized upon exercise and the potential for future gains, making it the comprehensive way to assess an option's value at any given point before expiration.