Pricing in Interest Rate Moves
In the same way that volatility can get priced in to an option’s value, so can
the interest rate. When interest rates are expected to rise or fall, those
expectations can be reflected in the prices of options. Say current interest
rates are at 8 percent, but the Fed has announced that the economy is
growing at too fast of a pace and that it may raise interest rates at the next
Federal Open Market Committee meeting. Analysts expect more rate hikes
to follow. The options with expiration dates falling after the date of the
expected rate hikes will have higher interest rates priced in. In this situation,
the higher interest rates in the longer-dated options will be evident when
entering parameters into the model.
Take options on Already Been Chewed Bubblegum Corp. (ABC). A
trader, Kyle, enters parameters into the model for ABC options and notices
that the prices don’t line up. To get the theoretical values of the ATM calls
for all the expiration months to sit in the middle of the actual market values,
Kyle may have to tinker with the interest rate inputs.
Assume the following markets for the ATM 70-strike calls in ABC
options:
Calls Puts
Aug 70 calls1.75–1.851.30–1.40
Sep 70 calls2.65–2.751.75–1.85
Dec 70 calls4.70–4.902.35–2.45
Mar 70 calls6.50–6.702.65–2.75
ABC is at $70 a share, has a 20 percent IV in all months, and pays no
dividend. August expiration is one month away.
Entering the known inputs for strike price, stock price, time to expiration,
volatility, and dividend and using an 8 percent interest rate yields the
following theoretical values for ABC options: