This lesson will focus on the Rho (ρ) Greek in option pricing models.Rho represents the theoretical value of change in an option’s value in relation to a 1% move in interest rates. The Rho for calls and puts with the same strike price and expiration date will be equal, bounded by what is known as put-call parity. This will be discussed in a future lesson.
Rho is positive for long call options and negative for long put options.
An investor is long a First Solar December 125 call
option that has a premium of $3.90 and a Rho value of .03.
If interest rates INCREASED by 1%, the call premium would INCREASE to
$3.93
(positive for long Rho positions)
if interest rates DECREASED by 1%, the call premium would DECREASE to
$3.87
(negative for long Rho positions)
On the short side, Rho is negative for written call options an positive for written put positions.
An investor writes a First Solar December 100 call
option that has a premium of $1.10 and a Rho value of .02.
If interest rates INCREASED by 1%, the call premium would DECREASE to
$1.08
(negative for short Rho positions)
if interest rates DECREASED by 1%, the call premium would INCREASE to
$1.12
(positive for short Rho positions)
The reason interest rates have an effect on option premiums is that if interest rate rise, it becomes more expensive to hold an underlying stock position, thus increasing the value of the call option. The opposite would be true for put options.
The Put/Call parity mentioned in the opening paragraph is an advanced topic that will be discussed in future lessons. For now, students should take time to understand the relationship between interest rates and option premiums.
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