What is Extrinsic Value?
601 reads · Last updated: December 5, 2024
Extrinsic value measures the difference between the market price of an option, called the premium, and its intrinsic value. Extrinsic value is also the portion of the worth that has been assigned to an option by factors other than the underlying asset's price. The opposite of extrinsic value is intrinsic value, which is the inherent worth of an option.
Definition
Extrinsic value refers to the difference between the market price of an option (i.e., the premium) and its intrinsic value. It is determined by factors other than the underlying asset's price. In contrast, intrinsic value is the inherent value of the option.
Origin
The concept of extrinsic value originated with the development of option pricing theories, particularly after the introduction of the Black-Scholes model in the 1970s, which provided a comprehensive framework for option pricing.
Categories and Features
Extrinsic value is primarily composed of time value and volatility value. Time value indicates that the longer the time until the option's expiration, the higher the extrinsic value, as there is more time to realize potential profits. Volatility value suggests that the higher the market's expectation of the underlying asset's price volatility, the higher the extrinsic value of the option.
Case Studies
Case 1: During the 2008 financial crisis, the stock prices of many companies fluctuated dramatically, leading to a significant increase in the extrinsic value of options. For example, AIG's stock options saw a substantial rise in extrinsic value as market volatility increased. Case 2: In early 2020, during the COVID-19 pandemic, Apple's stock options experienced a notable increase in extrinsic value due to market expectations of future uncertainties.
Common Issues
Investors often confuse extrinsic value with intrinsic value, assuming that an option's market price is entirely determined by its intrinsic value. In reality, extrinsic value plays a crucial role in option pricing, especially in highly volatile markets.
