Risk-Free Rate Homework Help

Risk-Free Rate

Risk-free rate (interest rate) has a positive relationship with the value of call option. The higher is the interest rate the higher is the Co. This is so because the final payment for the purchase of shares is delayed till the time the option is exercised at some future date. The higher is the R, the lower is the PV of exercise price; since this price is to be subtracted from S, as per Equation 10, the value of call option increases. To put differently, the PV of exercise price will be less with higher discount rate causing higher value of C. Assuming 10 per cent discount rate (in place of 7 per cent), the value of C increases to Rs 6.83 (i.e. Rs 125 – Rs 118.17, PV of Rs 130 x 0.909, PV factor at 10%), other factors remaining unchanged.

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