A. The time to maturity decreases. B. Interest rates increase. C. The underlying share price falls. D. The volatility of the underlying share price increases.
The correct answer is: The volatility of the underlying share price increases.
Suppose, for example, that the exercise price for a call option equals the current market price of the share, and there is a 50% probability that the share price will rise before the expiration date of the option and a 50% probability that it will fall.
The pay-offs for the holder of the call option will be as follows. (Let the share price at expiration = S and the exercise price of the option be E).
Outcome
Pay-off
Probability
EV of option
Share price rises: option is exercised
E–S
0.5
0.5(E–S)
Share price falls: option is worthless and not exercised
0
0.5
0
0.5(E–S)
The greater the difference between E and S (that is to say, the greater the potential volatility of the share price) the greater will be the market value of the call option.
