Question
If interest rates rise, what happens to the value of a call option , all else constant?
Solution
This occurs because of the following factors:
- Reduced Present Value of Strike Price:Â A call option allows the holder to buy the underlying stock at a specified strike price in the future. When interest rates rise, the present value of that future strike price payment decreases, making the option more valuable today.
- Opportunity Cost of Capital:Â Purchasing a call option requires less upfront capital than purchasing the stock directly. When interest rates are higher, the interest income earned on the saved capital (or savings from not borrowing as much) increases, increasing the appeal of the call option.
- Positive Rho:Â In options pricing models like Black-Scholes, the sensitivity to interest rate changes is measured by "rho". Call options generally have a positive rho, meaning they move in the same direction as interest rates. While put options decrease in value when interest rates rise, call options experience a rise in value.Â
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