Higher interest rates generally result in higher call premiums, according to option pricing models, because the present value of the strike price is subtracted in these models. Hence, higher interest rates correspond to lower present values, so less is subtracted, leading to higher call prices.
A more intuitive way to understand why higher interest rates increases call prices is to understand that a call is like a forward contract, in that it allows the holder to buy the stock at a specified price before the expiration date, so the money that would have been used to otherwise buy the stock can, instead, be invested in Treasuries to earn a risk-free interest rate until the date in which the stock is purchased. Because the stockholder incurs a cost of holding the stock, which is the forfeited interest that could otherwise be earned, a higher price is charged for the call to compensate the stockholder for the forfeited interest. By the same reasoning, dividends decrease the price of calls because only the stockholder is entitled to receive the dividends, not the call holder.
On the other hand, the application of the put-call parity theorem to option pricing models yields lower put premiums due to higher interest rates.
Rho is the amount of change in premiums due to a 1% change in the prevailing risk-free interest rate. Thus, a rho of 0.05 means that the theoretical value of call premiums will increase by 5%, whereas the theoretical value of put premiums will decrease by 5%, because put premiums move opposite to interest rates.
The values are theoretical because it is market supply and demand that ultimately determines prices. In fact, rho can be misleading because interest rates may have a larger effect on the price of the underlying, which is a more significant determinant of option prices. The demand for stocks, for instance, varies inversely with interest rates. When interest rates are low, investors buy stocks in an attempt to earn more income. When interest rates rise, risk-averse investors move their money from stocks to safer bonds and other interest-paying investments. Thus, puts will tend to increase with interest rates while calls will decrease, because the price of the underlying will have a more significant effect on option premiums than the interest rate.
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