Stock Market Volatility

Submitted by: Andrew Clacy

• Volatility - in general, the greater the volatility of the underlying asset, the greater the time value will be.

This is due to the fact that the writer is exposed to a greater probability of incurring a loss, and will require higher premium income to compensate for the increased risk.

Interest rates - an increase in interest rates will lead to higher call option premiums and lower put option premiums, all else being equal.

This reflects the cost of funding the underlying shares. The taker of a call option can defer paying for the shares until the option’s expiry date, and invest the funds elsewhere during this period. As interest rates rise, more interest can be earned on the funds, so the call option is worth more to the option taker.

The effect of an interest rate rise is the op

 

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posite for put options, as the taker is deferring the receipt, rather than the expenditure of funds.

When using interest rates in an option pricing model, the risk free rate which matches the life of the option is usually used. So, for example, for a three month option the three month bank bill rate would be used.

Dividends - if a dividend is payable during the life of an option, the premium of a call option will be lower, and the premium of a put option higher, than if no dividend was payable.

This is because shares tend to fall in value on going ex-dividend, all else being equal. Anything that leads to lower share prices will make call options less valuable, and put options more valuable.

Market expectations - ultimately, the pressures of supply and demand determine the value of options.

Theoretical fair value

Pricing formulae are available to help you determine the theoretical ‘fair value’ of an option. The Cox Ross Rubinstein binomial model is widely accepted as the industry standard for equity options.

However, you should realise that pricing models calculate fair value based only on estimates of volatility, interest rates and other factors. The price at which an option trades may not necessarily be the same as its fair value.

Nik Halik



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