Terminology and valuation relating to a call option. A Milwaukee manufacturer uses copper in its manufacturing operations and anticipates that copper prices will increase over the next several months. On February 1, the company purchased an at-the-money May call (buy) option for $800. The option has a notional amount of 25,000 pounds and a strike price of $0.80 per pound. Copper spot rates and option values at selected dates are as follows:
|
Spot Rate per Pound |
Option Value |
|
|
28-Feb |
$79 |
$700 |
|
31-Mar |
81 |
800 |
|
30-Apr |
85 |
1,400 |
|
15-May |
87 |
1,750 |
1. For each of the above dates, calculate the intrinsic value and the time value of the option.
2. If the call option were designated as a hedge of a forecasted purchase of copper, explain how the changing value of the option would be recognized in the income statement over time.
3. If the price of copper remained below $0.80 per pound subsequent to February 1, calculate the effect on earnings traceable to the hedge.
4. Explain why the pure time value of the option would be expected to decrease over time.