Cash And Accural Paper

Cash And Accural Paper

Dividends, Interest Rates And Their Effect On Stock Options
by Jim Graham, Registered Investment Advisor, OptionVue.com (Contact Author | Biography)
While the math behind options-pricing models may seem daunting, the underlying concepts are not. The variables used to come up with a "fair value" for a stock option are the price of the underlying stock, volatility, time, dividends and interest rates. The first three deservedly get most of the attention because they have the largest effect on option prices. But it is also important to understand how dividends and interest rates affect the price of a stock option. These two variables are crucial to understanding when to exercise options early.

Black Scholes Doesn't Account for Early Exercise
The first option pricing model, the Black Scholes model, was designed to evaluate European-style options, which don't permit early exercise. So Black and Scholes never addressed the problem of when to exercise an option early and how much the right of early exercise is worth. Being able to exercise an option at any time should theoretically make an American-style option more valuable than a similar European-style option, although in practice there is little difference in how they are traded.

Different models were developed to accurately price American-style options. Most of these are refined versions of the Black Scholes model, adjusted to take into account dividends and the possibility of early exercise. To appreciate the difference these adjustments can make, you first need to understand when an option should be exercised early.

And how will you know this? In a nutshell, an option should be exercised early when the option's theoretical value is at parity and its delta is exactly 100. That may sound complicated, but as we discuss the effects interest rates and dividends have on option prices, I will also bring in a specific example to show when this occurs. First, let's look at the effects interest rates have on...