Question

Define and briefly explain the relationship between value of a call option and the following five factors: Stock price, exercise price, interest rate, time to expiration, volatility of stock price.

Answer 1

1. Relationship between call option & stock price:

Normally, when the stock price goes up, & other factors remaining constant, then value of call option will go higher. If the call option has gone down, then other factors must have changed.

2. Call option & exercise price:

The exercise price is same as strike price of an option. Calls options are exercised by the traders or investors only if the price of the underlying asset is being traded above the strike price. Call options give the right to buy the stock at strike price even if stock price rallies aggressively.

3. An increase in interest rate will help in saving on outgoing interest on the loaned amount or an increase in the interest receipt on the saving account. Both will be positive for call option + savings. Hence a call option’s price will increase in order to indicate the benefit from increased interest rates.

4. The longer an option has until time to expiration, greater is the profitability. As expiration approaches, value of an option can decrease. The asset’s volatility is a factor in time value. If the asset is highly volatile greater the movement of price before expiration & vice versa. Hence the time value will be lower if price is not expected to vary much.

5. Volatility is the degree to which price moves. It is the speed & magnitude of underlying price changes. Hence greater the expected volatility, higher the option value.