14 Part I: Basic Properties ol Stodc Options 
stock has the ability to move a relatively large distance upward, buyers of the calls are 
willing to pay higher prices for the calls - and sellers demand them as well. For exam­
ple, if AT&T and Xerox sell for the same price (as they have been known to do), the 
Xerox calls would be more highly priced than the AT&T calls because Xerox is a more 
volatile stock than AT&T. 
The interplay of the four major variables - stock price, striking price, time, and 
volatility can be quite complex. While a rising stock price (for example) is directing 
the price of a call upward, decreasing time may be simultaneously driving the price 
in the opposite direction. Thus, the purchaser of an out-of-the-money call may wind 
up with a loss even after a rise in price by the underlying stock, because time has 
eroded the call value. 
THE TWO MINOR DETERMINANTS 
The Risk-Free Interest Rate. This rate is generally construed as the current 
rate of 90-day Treasury bills. Higher interest rates imply slightly higher option pre­
miums, while lower rates imply lower premiums. Although members of the financial 
community disagree as to the extent that interest rates actually affect option price, 
they remain a factor in most mathematical models used for pricing options. (These 
models are covered much later in this book.) 
The Cash Dividend Rate of the Underlying Stock. Though not clas­
sified as a major determinant in option prices, this rate can be especially impor­
tant to the writer (seller) of an option. If the underlying stock pays no dividends 
at all, then a call option's worth is strictly a function of the other five items. 
Dividends, however, tend to lower call option premiums: The larger the dividend 
of the underlying common stock, the lower the price of its call options. One of 
the most influential factors in keeping option premiums low on high-yielding 
stock is the yield itself. 
Example: XYZ is a relatively low-priced stock with low volatility selling for $25 per 
share. It pays a large annual dividend of $2 per share in four quarterly payments of 
$.50 each. What is a fair price of an XYZ call with striking price 25? 
A prospective buyer of XYZ options is determined to figure out a fair price. In 
six months XYZ will pay $1 per share in dividends, and the stock price will thus be 
reduced by $1 per share when it goes ex-dividend over that time period. In that case, 
if XYZ's price remains unchanged except for the ex-dividend reductions, it will then 
be $24. Moreover, since XYZ is a nonvolatile stock, it may not readily climb back to 
25 after the ex-dividend reductions. Therefore, the call buyer makes a low bid - even