Sch_Vol_2_Mock_3_PM_Q_115 attractive, following, increase, interest, opposite

sweetgirl

hello, please anyone clear up the following for me.

the answer to this says "interest rates have a direct relationship with call option and an inverse relationship with put options"

Surely not!

Interest rates have an inverse relationship with call options (as when interest rates fall the bond issues is more likely to be called because refunding is more viable and the opposite being the case for when interest raise increase making refunding not equally attractive) and a direct relationship with put options (as when interest rates fall the bond itself increases in price as it offer better return and so the holder is unlikely to sell if for a lesser amount to the issuer whereas if interest increase the bond looses value as it offers less competitive returns and so it may well benefit the holder of the bond to put it and make a better price).

IF my reasoning is correct the right answer is B not C.

thanks for any contributions and please do point out errors in my thinking

Siddimaula

You are incorrect. Calls have a direct relationship with interest rates for this reason: If I own a call, i am waiting around to buy the stock, so if int rates go up, then I could get rid of the call and invest at that now higher risk free rate, therefore the call value must go up for me to stay with the call rather than ditching it for rf rate.

puts are inversely related because: i am waiting around to SELL the stock. So if rates go up, then I can ditch the put and earn the higher RF rate. Therefore that is an inverse relation: int rts went up but the value of the put goes down cuz it's not worth as much to me anymore.

If rates go down, and i am waiting around to sell the stock, then i dont want to get rid of the put to earn that low int rate, i want to keep the put, so that value of the put goes up.

Let me know if that helps.

dece2011

I Think Penny-Wenny interpreted it as a callable bond..whereas it is actually a derivatives question where

Minimum value of a call is = S - X/((1+RFR)^t)

When the interest rate rises, the value of the second part of the expression decreases as the interest rate rises, hence the Value of option rises.

disiz64

you are both right! thanks very much indeed!

FVPV

I made the same mistake because I interpreted it as a bond when it was clearly a derivatives questions! I'm reassured



Edited 1 time(s). Last edit at Wednesday, May 25, 2011 at 12:57AM by zinamarina.