Financial Accounting and Reporting-CPA Practice Exam

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What is the formula for the value of an options contract?

Market Price - Strike Price
Intrinsic Value + Time Value
Strike Price + Market Price
Time Value - Intrinsic Value

The correct answer is: Intrinsic Value + Time Value

The formula for the value of an options contract is correctly identified as the sum of intrinsic value and time value. Intrinsic value represents the difference between the current market price of the underlying asset and the strike price of the option, but only when the option is in-the-money. If the option is out-of-the-money, the intrinsic value is considered to be zero. On the other hand, time value accounts for the potential of the option to gain further value before expiration, which is influenced by factors such as the time remaining until expiration and the underlying asset's volatility. By combining both the intrinsic and time values, investors can assess the total worth of an options contract. This framework allows for a comprehensive understanding of the option’s value, as it reflects both immediate worth (intrinsic) and potential future worth (time). Other options may describe components of the options valuation process but do not fully capture the correct formula for determining the total value of an options contract.