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,
- When interest rates rise, call option goes up, put option goes down. The logic behind it is a person would rather buy the call than a leveraged position on the underlying when interest rates are high because they would pay more interest on the leveraged position. On the other hand, a put option would become less attractive because you lose more interest waiting to sell the underlying. 2) Volatility increases both the value of put and calls. Both options have more chance of moving into the money if the price swing is big.
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
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.
On the other hand, a put > option would become less attractive because you > lose more interest waiting to sell the underlying. @Andy could you please explain this option further. I am not able to understand why would you have to wait to sell? Is it because of comparable bonds will have lower price since the interest rate is up?
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?
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 
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)
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.
Kiakaha: You pretty much have it spot on.
JoeyDVivre Wrote: ------------------------------------------------------- > 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. Thanks for the insight. Could you also correlate Andy’s reasoning and my reasoning with delta and rho and tell us how should we evaluate call and put value?
@ AndyNZ When we talk about Interest Rate increase/decrease, the call/put option is that of a stock or a bond? I guess the logic will reverse for a bond. Pls enlighten me here !