Time value has definitions both in options pricing and the time value of money.
Time Value in Option Pricing
When dealing with an option, such as a stock option, the option’s price has two conceptual components – the intrinsic value and the time value.
Time has a value. Longer dated option expiry dates attract higher prices because they allow more time for the strike price to be reached.
An option trading at its intrinsic value with no time value is said to be trading at parity and its expiration is probably imminent.
Time Value and Money
Money’s value changes with time as a result of interest earned and inflation. The effect of time on the value of money needs to be taken into account when assessing investments. Key concepts are Present Value and Future Value.
For example, consider the following situation.
An investor can achieve a guaranteed interest rate each year of 7 percent. What is worth more to this investor: $100 today to invest at 7 percent or a guaranteed payment of $200 in 6 years time?
Financial tables or calculations enable us to find the present value of $200 from 6 years in the future with a 7% interest rate environment.
PV = FV / (1 + i)n
PV = Present Value
FV = Future Value
i = interest rate
n = number of years
In our example,
PV = 200 / (1 + 0.07)6
i.e. PV = $133.27
The present value of the sum promised in six years time is higher than today’s $100 and the investor should choose this option to maximise his return.
Present value is the current worth of a future sum of money or sums of money at a specified rate of return.
When we assess the present value of a future sum, we need to choose an approprate discount (interest) rate.
In the example above, the discount rate is 7%. The higher the discount rate chosen by the investor, the lower the present value of the future money.
Using an appropriate discount rate is essential in the valuation of future cash flows and this can be as much of an art as it is a science.