FoundationNumeric answerFree solution

A stock trades at $50\$50 and the $45\$45 call trades at $7\$7. How much of the premium is extrinsic value?

Answer with a number. Fractions, powers and expressions like 23/6 or C(52,5) are read correctly in practice.

Show the answer and worked solution

Answer

22

Split the premium into intrinsic and extrinsic. Intrinsic is what you would collect by exercising right now, max⁡(S−K,0)=50−45=5\max(S - K, 0) = 50 - 45 = 5; extrinsic is everything else, 7−5=27 - 5 = 2. The extrinsic part is what you are paying for the possibility of further movement, and it is exactly what you forfeit by exercising early rather than selling. That is why the split is worth making out loud: it is the same $2\$2 that answers the early-exercise question on the next screen.

Worked solution

  1. Formula
    extrinsic=C−max⁡(S−K, 0)\text{extrinsic} = C - \max(S - K,\ 0)
  2. Substitute
    =7−5= 7 - 5
  3. Solve
    =2= 2
  4. Answer
    $2\$2

Sanity check. Extrinsic value is never negative – if it were, the bound C≥S−KC \ge S - K would be violated.

Takeaway: Premium splits into intrinsic and extrinsic; extrinsic is what you forfeit by exercising early.

Answer it in practice – your answer is marked and recorded.

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A stock trades at $50 and the $45 call trades at $7. · QuantMax