How Interest Rates Affect Call Option Values
Summary
The document explains why a rise in interest rates can increase a call option's theoretical value, despite the possibility that higher rates may weigh on share prices. In option valuation, the strike payment is made in the future, so a higher discount rate lowers its present value. This makes the right to buy the underlying at that future strike more valuable, all else equal.
It also notes that interest rates and stock prices do not have a fixed inverse relationship. The answer describes a possible macroeconomic setting in which rates rise alongside strong equity performance, such as when inflation expectations increase amid limited supply and companies retain capacity to meet demand. These are conceptual explanations rather than a quantitative analysis; the document gives no model derivation or evidence establishing how large either effect will be in a particular market.
Key ideas
- A higher interest rate reduces the present value of a call option's future strike payment.
- That discounting effect supports a higher call value, all else equal.
- The relationship between interest rates and equity prices is not consistently inverse.
- Macroeconomic conditions can cause rates and share prices to rise together.
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Full text
# When interest rates go up, why do call option prices go up? # When interest rates go up, why do call option prices go up? I studied that generally speaking, interest rates and share prices have an inverse relationship. When interest rates go up, share prices go down. If interest rates go up, wouldn't people be less inclined (i.e less demand) to buy call options (as the price is going down), and hence the call options price would go down? ## Answer by JeanGuillaume (score 6, accepted) https://quant.stackexchange.com/a/46344 When interest rates go up, there are two effects that explain the positive link with the increase in the price of a call option (according to Hull). There is the quote: " As interest rates in the economy increase, the expected return required by investors from the stock tends to increase. In addition, the present value of any future cash flow received by the holder of the option decreases". The second explanation is the most intuitive for me. The present value of the payment is smaller (if you exercised the option). and so, basically you get the same thing (the stock) for a smaller present price. By the way, the relationship between interest rates and stocks is not so straightforward. For a counterexample, look at the last years when the FED was hiking its interest rate and we saw a huge rally in the S&P 500. Interest rates increase due to increase in expected inflation and if this inflation is pushed by a limited supply, that means that companies are doing well regarding their capacities.
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