Question

Discuss (explain) why exercise price and risk-free rate of return may have opposite effect on call option and put option

Answer 1

Exercise Price..

The exercise price is the price at which an underlying security can be purchased or sold when trading a call or put option, respectively.

A put gives investors the right, but not the obligation, to sell a stock in the future. Investors buy puts if they think the stock is going down or if they own the stock and want to hedge against a possible price decline. They buy puts because it allows them to sell the stock at the strike price of the option, even if the stock falls dramatically

A call gives investors the right, but not the obligation, to buy a stock in the future. Investors buy calls if they think the stock is going up in the future or if they sold the stock short and want to hedge against a possible surge in price. Calls give them the right to buy at the strike price even if the stock price rallies aggressively.

Risk Free Rate of return.

The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. The real risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.

Here, the simplest way to think about this is as a rate of return on a stock. Let’s say you have the choice between buying a bond worth $1000 or one share of stock priced at $1000. If you know the risk-free rate of interest is a known 5%, you would expect the stock price to increase by more than 5% on average. Otherwise, why would you buy a share of stock instead of investing in a risk-free bond? Therefore,

As the time the risk-free rate increases, the value of a call option increases.

However, as the risk-free rate increases, the value of a put option decreases.