Hello,
One factor that determines the option value is the “risk free rate of interest”.
An increase in the risk free rate will increase call option values and vice versa.
An increase in the risk free rate will decrease put option value and vice versa.
I am not understanding the concept behind it. Help would be greatly appreciated.
Thank you.
This method of using Put-Call Parity to understand this might not be the right way - but helps to conceptualize this. Of course this implies all the other moving pieces may not change.
P+S = C+X/(1+r)^t
or C = P+S - X/(1+r)^t
Now when R increases - since R is on the denominator - you are subtracting a smaller number. So C Increases. (Value of Call option increases).
Now
P = C + X/(1+r)^t - S
A smaller number is getting added when R increases - so the value of the Put Option drops
The easiest way to see this is through put-call parity:
p0 + s0 = c0 + X / (1 + r)
If r increases , then the price of the bond decreases; to maintain equality, at least one of two things has to happen:
If r decreases , then the price of the bond increases; to maintain equality, at least one of two things has to happen: