Option Pricing Setting the Scene

4 The risk free interest rate during the option s life 

6 The value of any dividends or cash flows paid by the underlying asset during the option s life 

Possibly the two most important of these factors are the current price of the underlying and the option s strike price. As noted above, the relationship between these two determines the option s intrinsic value. The value of a call option thus rises and falls with the price of the underlying. And given several calls on the same asset, the higher the strike, the lower the option price. All this is reversed for a put option. 

One such factor is the coupon payments made by the underlying during the option s life. These payments reduce the price of the underlying asset on the ex-dividend date and so depress the price of a call option and boost that of a put. 

A rise in interest rates increases the value of most call options. For stock options, this is because the equity markets view a rate increase as a sign that share price growth will accelerate. Generally, the relationship is the 

One such factor is the coupon payments made by the underlying during the options life. These payments reduce the price of the underlying 

A rise in interest rates increases the value of most call options. For stock options, this is because the equity markets view a rate increase as a sign that share price growth will accelerate. Generally, the relationship is the same for bond options. Not always, however, since in the bond market, rising rates tend to depress prices, because they lower the present value of future cash flows. A rise in interest rates has the opposite effect on put options, causing their value to drop. The risk-free interest rate applicable to a bond option with a term to expiry of, say, three months is a three-month government rate—commonly the government bond repo rate for bond options, usually the T-bill rate for other types. 

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