InvestorQ : What happens to the value of a put option when the interest rates go down to a lower level? # What happens to the value of a put option when the interest rates go down to a lower level? Answer 1 year ago

Let us look at a live example to understand the impact of a reduction in interest rates on the value of the put option. Let us take the case when the interest rate goes down by 100 basis points from 5% to 4%.

 Input Data Input Data Stock Price now (P) 120 Stock Price now (P) 120 Exercise Price of Option (EX) 125 Exercise Price of Option (EX) 125 Number of periods to Exercise in years (t) 0.08333 Number of periods to Exercise in years (t) 0.08333 Compounded Risk-Free Interest Rate (rf) 5.00% Compounded Risk-Free Interest Rate (rf) 4.00% Standard Deviation (annualized s) 30.00% Standard Deviation (annualized s) 30.00% Output Data Output Data Present Value of Exercise Price (PV(EX)) 124.4803 Present Value of Exercise Price (PV(EX)) 124.5840 s*t^0.5 0.0866 s*t^0.5 0.0866 d1 -0.3800 d1 -0.3896 d2 -0.4666 d2 -0.4762 Delta N(d1) Normal Cumulative Density Function 0.3520 Delta N(d1) Normal Cumulative Density Function 0.3484 Bank Loan N(d2)*PV(EX) 39.8844 Bank Loan N(d2)*PV(EX) 39.4896 Value of Put 6.8345 Value of Put 6.9052

The strike price pertains to the expiry date. For example, when you buy a 125 strike Put option when the market price is Rs.120 then it is the right to sell the stock at Rs.125 on the last Thursday of the month, which is the F&O expiry. But the market price pertains to the current date. Hence to make them comparable, you need to calculate the present value of the excise price or the strike price. This present value discounting is done based on the interest rates and that is why interest rates are relevant to the calculation of the call option value. In the above instance you can see that the interest rates have moved down by 100 basis points from 5% to 4% and as a result the present value of the excise price as shown in the above table has gone up. This widens the positive gap between the stock price and the market price or it narrows the negative gap between the stock price and the market price and therefore ends up making the put option more valuable. It can be seen that the impact of the 100 bps change in the interest rates on the value of the put option is not very significant. That is because it is more of a second level change.

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