Falling Interest Rates...
How Are Options Impacted

Since the start of the year, the Federal Open Market Committee (FOMC) has cut short-term interest rates 10 times. This has been in response to both a slowing economy and efforts to keep money liquid following the attack on the United States on September 11. The Federal Funds Rate, the interest rates that banks use to lend each other money overnight, have declined to a 40-year low.

Following the latest interest-rate decision on November 6, the Fed stated that the risks continue to weigh toward a slowing economy, which is being interpreted as meaning the monetary policy making body will be ready to lower interest costs again at its next scheduled meeting on December 11.

In addition to the actions of Mr. Greenspan and Co., The U.S. Treasury decided to suspend auctions on the 30-year T-bond. This has resulted in a sharp demand for 30-year paper, which has pushed long-term interest rates sharply lower. Additionally, the yields on shorter-term paper have also declined as demand spilled over to the shorter-term instruments.


Figure I - Federal Funds Rate for 2001.

IMPLICATIONS FOR CALL OPTIONS

Options contracts are sensitive to certain variable factors. These variables include the underlying price, relationship between that price and the actionable or exercise price of the contract, dividend payments, time-to-expiration, and a quantifiable factor for risk. Another key factor is interest rates, which help determine the cost-of-carry for holding a position to expiration. These variables are combined to determine the time-premium for an options contract. The time premium is then added to the intrinsic or economic value of the contract, resulting in the option premium.

The value of a call options contract is strongly influenced by the change in interest rates. Rising interest rates result in higher costs for would-be stock purchasers, including market-markers and specialists. As the cost-of-carry increases, so do the premiums for call option contracts. Conversely, the premiums for call options decline as interest rates fall. Since interest cost has a direct economic impact on holding the underlying stock, covered call writers must be compensated for the changes in interest rates.

Changing interest rates have a linear relationship to the changes in the option premiums for their respective contracts. Figure II below illustrates the relationship between the cost-of-carry and an at-the-money call option with 3-months till expiration. In this instance, the theoretical value of the call rises or falls nearly $0.09 per share based on a 1% change in interest rates.


Figure II - Theoretical value of a 3-month at-the-money call option based on changing interest rates.

INTEREST RATES AND PUT CONTRACTS

Put options are sensitive to the same variables as call options. While changing the variables will impact the valuations of the put contracts, the relationships are not the same as those of the calls. This is especially true for changing interest rates. In this respect, puts and calls have opposing relationships. As interest rates increase, the associated put premiums decline, while a decline in interest rates will result in higher put premiums.

Most market-makers and trading professionals will purchase the underlying stock of a put option when buying the put contract. Conversely, when writing a put contract, they will sell the shares short to offset the risk of the contract. Since these professionals pay and collect interest based on the share position held, a direct economic relationship can be established based on the movement of interest rates. Since the opposing position is taken, an inverse relationship between interest rates and put premiums can be linked. As a result, rising interest rates will result in a drop in put premiums while falling interest rates will cause the premiums to rise.

The impact of the changes between interest rates and put options are not as significant as those of the calls. This is partially due to the relationship between long interest-rate charges and short interest-rate charges.

Figure III shows the relationship between changing interest rates and a 3-month at-the-money put option. This is the complimentary contract to the call option used in the preceding section. Notice the linear relationship between the changing interest rates and the changes in the put premiums. In this case, the theoretical value of the put rises and falls nearly $0.075 per share based on the change in the respective interest rates.


Figure III - Theoretical value of a 3-month at-the-money put option based on changing interest rates.

CONCLUSION

As we have illustrated, the changes in interest rates have a direct impact on the values of listed options contracts. Rising interest rates cause call premiums to rise and put premiums to fall.

Conversely, declining interest rates result in a decline in call premiums and a rise in put premiums. When the changes in the puts and calls are combined, they should equal the total change in the cost-of-carry associated with owning or selling short the underlying stock position.

As the Federal Open Market Committee (FOMC) continues to ease monetary policy by cutting short-term interest rates, call premiums have declined and put premiums have risen. Many investors have failed to notice the impacts of these changes due to other changes in the variables that comprise option premiums, including the dramatic shift in volatility levels.

The impact of changing interest rates has resulted in a cross into new territory for option premiums. Listed option contracts were first introduced in 1973. Interest rates in the United States have reached the lowest levels since 1961. Therefore, call option premiums are at their lowest levels ever, when judged on an interest rate basis, while put option premiums are at their highest levels in history.

Changes in option premiums based on a 1% change in interest rates can be determined using an options pricing model program. The value is based on a factor known as "Rho." Rho values are available on the Advanced Options screen Ivolatility.com's website.

Options investors and traders should be aware of these relationships and changing environments that will impact the valuations and returns. Since the variables are in a constant state of fluctuation, potential profits and risks can be dramatically impacted. Additionally, falling interest rates usually have a positive impact on stock prices, and this impact can be material depending on the industry group and companies involved.