Financial Accounting and Reporting-CPA Practice Exam

What are the components of an options contract's time value?

1. Intrinsic Value - Market Value

2. Time remaining until expiration

3. Market Price + Intrinsic Value

4. Option Value - Intrinsic Value

The correct answer is: Option Value - Intrinsic Value

The time value of an options contract is defined as the difference between the overall value of the option and its intrinsic value. Intrinsic value represents the profit that would be realized if the option were exercised immediately, while the time value reflects the potential for the option to gain additional value before its expiration due to changes in the underlying asset’s price. In this context, option value refers to the market price of the option, which encompasses not only the intrinsic value but also the time value. Subtracting the intrinsic value from the total option value gives you the time value. This concept is significant because it emphasizes how the remaining time until the contract expires can impact an option’s market price. When considering the other choices, they do not adequately capture the definition of time value in relation to its intrinsic value. The second option, which mentions the "time remaining until expiration," disregards the necessity of relating this time to the overall option value. Similarly, both the first and third options introduce concepts that do not align with the straightforward definition of time value found in financial accounting or derivatives analysis. Therefore, the correct choice highlights the calculated relationship between option value and intrinsic value to clearly define time value.