Why Interest Rates Affect Option Prices

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On Tuesday, once again we saw the RBA wave the white flag on the economy, as it lowered the official cash rate by another 0.25%. Of course, the latest move had as much to do with the exchange rate as it did with trying to boost the economy.

Yield-hungry money flowing into Australia puts upward pressure on the exchange rate, as overseas investors need to first convert their funds into Aussie dollars before they can invest. The RBA fears that too high an exchange rate will add yet another stumbling block to an already fumbling economy.

Low interest rates are now doing just the opposite of what they’re intended to do. Lowering rates is supposed to spur an increase in spending and drive growth. Yet to many businesses, it’s now become a warning sign that the RBA is panicking — yet another reason to hold off on future investment.

Low rates have also forced many savers to move more of their money out of cash investments and into dividend-paying shares. With the market yield around double that available on term deposits, dividends are an obvious and popular way to supplement an income.

But they’re not the only way. Another strategy to generate income (other than dividends) is to write call options over existing shares. In option jargon, it’s called a ‘covered call’.

Under this strategy, the call option writer (seller) agrees to hand over their shares at an agreed price, known as the strike (or exercise) price, if the option is exercised. In return, the call option buyer pays the seller a premium for the option, which gives the buyer the right to lock in a future entry price. As options have a finite life, the goal for the option seller is to capture the time decay of the option.

While low interest rates are forcing many investors to find other ways to generate income — such as the covered call strategy — what is often missed is the impact of interest rates on option prices. Option pricing always needs to account for interest rates, or, the time value of money (TVM).

The TVM is based on a very simple premise. That is, that $100 in your hand right now is worth more to you than it would be in six months’ time. That’s because it can be invested in the meantime to generate income and/or capital growth.

Even with government bonds trading with negative yields in over a dozen countries, we could still invest that $100 here in Australia and make a positive return — albeit a modest one.

But how does this flow through to option prices? Let’s start by looking at a call option.

Call Options

If you buy a call option, you’re paying for the right to buy the underlying shares at a fixed price at any time until it expires. If the option premium didn’t include interest rates — that is, the cost of money — the call option buyer would have an unfair advantage.

The best way to see how this advantage would play out is by looking at a comparison between buying shares outright, and buying call options.

If an investor buys shares, they’ve got to pay for them in full, two days after the transaction. But if they could buy a call option that didn’t include interest rates, they’d only need to pay a fraction of the share purchase cost upfront (via the premium), and park the rest of their funds in an interest-bearing deposit.

In effect, it would be a double win. The option would allow them to take part in any potential upside in the share price, while they earn interest income in the meantime on their funds.

With interest rates as low as they are now, it might not seem like such a big deal. Every time rates increased, though, it would be a further advantage to the call option buyer. Imagine if interest rates went up to 7–8%; it would work even more to their favour.

The other side is that the call option writer is also giving up the interest they could earn if they sold their shares now — by putting the proceeds in the bank — rather than defer it until the possible exercise of the option later.

You can see that, without being compensated for TVM, there’s little incentive to write a call option. However, the opposite applies with put options.

If you recall, a put option gives the buyer the right to sell the underlying shares at a fixed price (the strike price) in the future. For taking on this obligation, the put option writer is compensated by the premium amount.

If put options didn’t factor in interest rates, the option buyer would be at a disadvantage. By not selling the shares now, they are missing out on the interest they could earn by putting the proceeds in the bank and earning income.

Again, with interest rates at record lows, this might not seem like such a big deal. But if interest rates were to rise, it would mean that they are foregoing even more income — so the less they’ll be prepared to pay for a put option.

Under this scenario, the advantage would be with the put option writer. They could keep the funds in the bank earning interest, only needing to take them out if the option was exercised.

The time value of money is a basic premise in finance that also affects the value of options. As interest rates increase, the value of a call option increases, while the value of a put option decreases. And as interest rates decrease, the opposite happens — call option premiums will decrease, while put option premiums increase in value.

After the rate cut last Tuesday, we can now only wonder how far the official cash rate might fall. But if interest rates ever went negative, this would flip the whole TVM argument on its head — something the options market in Australia has never experienced.

If you’d like to learn more about how you can use options as a long term wealth creation strategy, click here.


Matt Hibbard,
For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.

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