Dividends and Interest Rates
Jim Graham

While the math behind options pricing models may seem complex, the underlying concepts are not. The variables used in these models are price (of the underlying asset), volatility, time, dividends, and interest rates. The first three of these deservedly get most of the attention because they have the largest effect on option prices. But it is still important to understand the effect dividends and interest rates have on options prices. 
 
The original Black-Scholes pricing model was designed to evaluate European-style options where early exercise is not permitted. American-style options give you the right of early exercise, which theoretically makes an American-style option more valuable than a similar European-style option. 
 
Black and Scholes never addressed the problem how much the right of early exercise might be worth but the majority of exchange-traded options carry with them the right of early exercise. But since their pioneering work, many modified Black-Scholes models have since been developed to allow the accurate evaluation of American-style options.
 
Interest Rates   
 
Let's first look at the effect of interest rates on option prices. An increase in interest rates will tend to drive up call premiums and decrease put premiums. To understand why this is, think about the effect of interest rates in the context of comparing an option position to simply owning the stock. Since it is much cheaper to buy a call option than 100 shares of the stock, the call buyer is willing to pay more for the option when rates are relatively high, since he can invest the difference in capital requirements between the two positions.
 
Interest rates have been low in recent years relative to historic rates in the United States When short-term rates were around 1.5% to 2.0%, interest rates had a minimal effect on option prices. Now that the Federal Reserve has followed a policy monetary tightening by steadily increasing the discount rate over the past couple years, short term rates are now closer to 5%.
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