Impact of Interest Rate and Return Volatilities on Options values values

towardsutopia21

I find this topic very intimidating.


Whats the impact on call and put option value when
1) Interest Rate Increase/decrease
2) Volatilities increase/decrease


Can someone pls enlighten me on these?

Thanks,

suyash1989

In the case of an interest rate sensitive underlier, there are two effects delta and rho. The delta effect is the effect of the changed value of the underlier because of the changing interest rate. Note that this effect is based on the duration of the underlier so the interest rates that matter are the rates to the cash flows of the underlier. For example, if you have a call option on a 10-yr zero, the only interest rate that matters is the 10-yr rate. The rho effect is the effect of the changed interest rate on your preference between keeping your money in interest bearing deposits and holding a call vs holding the asset. Note that the interest rate here that matters is the interest rate until the expiration of the option. If the option is a 3 month option on a 10-yr zero the interest rate that matters here is the 3 month rate.

Given parallel shifts in interest rates, duration > option tenor, etc, delta effect is usually much bigger than rho.

Edit: Put options are about the same except that put option rho is about preference for shorting the underlier and keeping proceeds in interest bearing deposits vs owning a put option.



Edited 1 time(s). Last edit at Thursday, May 19, 2011 at 10:43AM by JoeyDVivre.

joemoran

Kiakaha: You pretty much have it spot on.

spartanag07

Well if both of them play the role in evaluating the value for the call and put option, which one weighs more and which option to select in the exam? I think one has to do with interest rate risk and other has to do with reinvestment risk(correct me if I am wrong here)

MythosHF

i think (and someone please correct me if I'm wrong) that there are different rules for call options on things directly affected by a change in interest rates (eg interest rate options, bond options etc) compared to call options on other things like stocks.

For call options on stocks, an interest rate rise will increase the value of the option (for the reasons AndyNZ and max outlined above).

But a call option on a bond essentially gives you the right to buy the bond at a certain price. If interest rates go up, the market price of the bond will go down, so the call option will lose value.

And a call option embedded in a bond (like the one sgupta described above) will also decrease in value if interest rates rise, because it's less likely that the bond will be called.

hope that makes sense and I'm on the right track with this, if not, please let me know

Bluetick1010

I don't know from where this reasoning got stuck in my head about call and put options and it's messing up everything:

When interest falls, likelihood of call increases as market rate is lower than the interest rate borrower/issuer is current paying, increasing the demand for call options, which will in turn increase the value of call option. same reasoning may be applied to put and in interest rate rise case. I know this reasoning is definitely wrong but I am not sure why it's wrong. I think I have read it somewhere and conclusion drawn from the reading was call option and prepayment option behave in a similar way. so I far I have been driving the call and put values using this reasoning and without any surprise getting most of the answers wrong. Did anyone remember reading this somewhere? Can someone identify any flaws in this reasoning so that I can just forget about it and follow Andy's reasoning. I remember reading Andy's reasoning as well, probably in a different context. But I am not sure why I remembered the wrong one. Am I mixing interest rate risk and reinvestment risk?

RobertA

I would say try to remember these relations rather than trying to derive in the exam. It's likely that you might derive the wrong answer in the exam due to the high pressure and time constraint.

evolsteevol

The quick way I would advise you to apply during exam time- when you are inclined to be nervous and cannot think straight:

Use Put-call Parity

Call = stock + put - X / (1+Rfr) ^n ( or PV (X) )

If Rfr increase, PV(X) decrease, value of call increase. Vice versa. This also applies to put


Hope this helps