How do interest rates affect option prices? Explain. |...

Name: Problem 3, Chapter 25: Fundamentals of Corporate Finance
Uploaded: 2021-06-07T19:27:50-08:00
Duration: 1 min 40 s
Channel: Kaylee Mcclellan
Description: How do interest rates affect option prices? Explain.

Key Concepts

Risk-Neutral Valuation

This concept refers to the method of pricing options under the assumption that all investors are indifferent to risk. In this framework, the expected payoffs from options are discounted at the risk-free interest rate. Consequently, changes in interest rates alter the discount factor in the option pricing models, impacting the present value of the option’s expected future payoff.

Time Value of Money

Central to finance, the time value of money explains that a dollar today is worth more than a dollar in the future due to earning potential. When interest rates increase, the present value of future payoffs decreases because they are discounted more heavily. This mechanism directly influences the pricing of options by modifying the value of the expected future cash flows.

Option Pricing Models

Models like the Black-Scholes framework incorporate interest rates as one of the key inputs. The risk-free rate is used to discount the future payoffs from the option, affecting both the intrinsic and the time value components of the option's price. Changes in interest rates lead to adjustments in the theoretical option price predicted by these models.

Put-Call Parity

This principle establishes a mathematical relationship between the prices of European call and put options with the same strike price and expiration. Interest rates are an integral part of this parity relationship, as they influence the cost of carrying the underlying asset until expiration. As a result, shifts in interest rates can alter the balance between call and put prices, reflecting changes in the market’s cost of capital.

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