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What Is Rho?
Rho measures how the price of an option changes with changes in interest rates. Rho is the least important of all the 5 option Greeks.
How Does One Use Rho?
Rho can be either positive or negative for an option. A positive Rho means that the price of the option is positively related to interest rates and vice versa, assuming all other factors remain the same.
For example, the price of an option with a Rho value of 0.01 will increase in price by Rs. 0.01 with a percentage point increase in interest rates and decrease in price by 0.01 with a percentage point decrease in interest rates. Calls have positive Rho value and puts have negative Rho values.
Rho’s Relationship With Time To Expiry
The value of Rho is generally higher when there is a long time until expiration and gradually decreases in value as the expiration date approaches. This is largely because there is less extrinsic value in an option as it approaches maturity and because of this, interest rates will have very little effect on the price of an option. Even when the Rho value is at it’s highest with a long time until expiration, the effect it has on price is quite small anyway.
Why Do Interest Rates Affect The Price of an Option?
The only time the Rho value is important is when interest rates are changing significantly. Interest rates do impact the value of calls. This is largely due to the carrying cost of holding stocks and other financial instruments. The carrying cost of holding such instruments is based on the money required to purchase them.
The money required may need to be borrowed in which case there would be an interest cost associated. Even if the money required was available, there would be an opportunity cost associated because that money could have been invested into any other interest-bearing security. Therefore, the higher the interest rates, the higher the carrying costs.
Buying calls on a financial instrument are cheaper than buying the financial instrument itself. Also, the carrying cost is built into the price of a call. Due to this, as interest rates go up, the price of the call also goes up as the increased carrying cost of holding the relevant security is reflected in the price.
Further, calls become more attractive as interest rates go up because the cost savings effect between buying calls and buying the relevant underlying security becomes more pronounced. This is because there is a greater return for putting cash in interest-bearing securities. This leads to an increased demand for calls which also increases the price of calls.
Overall, the Rho Greek doesn’t have much effect on the price of an option which is why it is one of the least significant Greeks out of the lot.
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