Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

In a deep out of the money natural resource option expiring in nine months, what will be the time value of money?

1. Greater than the option premium.

2. Less than the option premium.

3. Equal to the option premium.

4. Less than zero.

The correct answer is: Equal to the option premium.

In the context of options, particularly a deep out-of-the-money natural resource option, the time value of an option is derived from the potential for future price movements of the underlying asset prior to expiration. Time value represents the additional amount that traders are willing to pay for the possibility that the option might become profitable before it expires. For a deep out-of-the-money option, the intrinsic value—if the option were to be exercised immediately—would be zero, as the market price of the underlying asset is significantly lower than the strike price. The option premium in this scenario primarily consists of the time value, since there is no intrinsic value. Over the nine months until expiration, even though the option is deep out of the money, it retains time value due to the uncertainty and volatility of the underlying asset’s price. This means that the time value of money in this option is equal to the total option premium, as there is no intrinsic value to subtract from it. Consequently, stating that the time value is equal to the option premium accurately reflects this relationship, as it highlights that the premium is entirely composed of time value when no intrinsic value exists.