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The price (value) of an option premium is determined competitively
by open outcry auction on the trading floor of the CBOT. The
premium is affected by the influx of buy and sell orders reaching
the exchange floor. An option buyer pays the premium in cash
to the option seller. This cash payment is credited to the seller's
account.
Prices for T-bond and T-note futures contracts are quoted
differently from the options premiums on these futures. Options
on these contracts are quoted in 64th of a point. Therefore,
a quote of -01 in options means 1/64, in futures, 1/32.
The option premium has two components: "intrinsic value"
and "time value." The intrinsic value
is the gross profit that would be realized upon immediate exercise
of the option. In other words, intrinsic value is the amount
by which the portion is in-the-money. (An option that is out-of-the-
money or at-the-money has no intrinsic value.)
For example, in December, a June Treasury bond futures contract
is priced at 82-00, while the June 80 call is priced at 3 10/64.
The intrinsic value of the option is 2-00:
Bond futures 82-00
Option strike price 80-00
Intrinsic value 2-00
Time value reflects the probability the option
will gain in intrinsic value or become profitable to exercise
before it expires.
Time value is determined by subtracting intrinsic value from
the option premium:
Time value = Option premium - Intrinsic value
= 3 10/64 - 2-00
= 1 10/64
Several other factors also have an impact on the premium.
One is the relationship between the underlying futures price
and strike price. The more an option is in-the-money, the more
it is worth. A second factor is volatility. Volatile prices of
the underlying commodity can stimulate option demand, enhancing
the premium. The greater the volatility, the greater the chance
the option premium will increase in value and the option will
be exercised; thus, buyers pay more while writers demand higher
premiums.
A third factor affecting the premium is time until expiration.
Since the underlying value of the futures contract changes more
within a longer time period, option premiums are subject to greater
fluctuation.
Some parallels can be drawn between the time value component
of an option premium and the premium charged for an automobile
insurance policy. The longer the term of the policy, the greater
the probability a claim will be made by the policyholder. This,
of course, presents a greater risk to the insurance company.
To compensate for this increased risk, the insurer charges a
greater premium. For example, the total dollar cost of a one-year
policy to insure the vehicle will be greater than a six-month
policy since the vehicle is being insured for twice as long.
The same is true with options on interest rate futures-the longer
the term until expiration, and the more volatile the underlying
market, the greater the option premium.
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