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Options – Part Three

Effects of dividends and interest rates on the theoretical value of options

Part one  |  Part two | Part three

We have already spoken about the key elements making up the price of an option: intrinsic value and time value.  However, in the previous article we only described these trends in a “perfect” world without taking into account, for the sake of simplicity, other very important factors such as the effect of dividends and interest rates.

In a way, options are an alternative to holding long or short positions on the underlying: for example, a portfolio consisting in a long call position and a short put position with identical strike price and duration will guarantee the same payout obtainable by way of a long position on the underlying security.  The main difference is that even though the profit and loss profile is completely identical, there is no ownership of the underlying: there is no right to any dividends paid on the security, but neither has it been necessary to make the disbursement that would have been required for the purchase.  The price of an option must therefore take into account these two factors.

Let us consider the case of dividends. We can simply state that they cause a reduction in the price of the shares on the detachment date and therefore have a negative effect on the value of a call option and positive on that of a put option.

The concept that owning an option is very similar, but not the same as holding the underlying helps us to understand the impact of interest rates on the price of an option.  The holder of a call benefits from an upward trend in the underlying as though he had ownership, but has postponed the disbursement necessary to purchase the security.  The financial leverage of these instruments is such that the option premium is just a small fraction of the value of the corresponding underlying.  The “price” of the possibility to defer the disbursement over time is the monetary interest rate.  The rate to which we are referring concerns non-risk and very liquid assets: as regards the Italian market, these could be short-term government securities.  The higher the interest, the greater the advantage of postponing the outflows (or leaving the money invested in the money market) and therefore the higher the premium on the call, i.e. the right to postpone the outflow, will have to be.

In the case of a put the reverse happens: the rise in rates corresponds to a fall in the value of the put.  The holder of the right to sell – if he is not a pure speculator – has acquired a form of “insurance” against downward trends in the security which is already present in his portfolio.  The higher the rates, the greater the advantage of liquidating the entire position to ensure a risk-free return on the money market, hence the smaller the premium that he is prepared to pay for the put.

The following chart helps us to graphically summarise what is explained here and in the previous article as regards the behaviour of the theoretical value of call and put options.