Papale on Rho

Greek letter for Rho

I am going to go out on a limb and guess that readership might be a bit light this week.  As much as I hate to admit it, many people might have planned other things to do on the day after Thanksgiving.  So for the diligent that are reading this, loosen  your belt as you dig into the leftovers and try to focus away from the TV or hold off on the nap for a few minutes.  I will keep it short.

Over the last 4 weeks I have gone over the greeks – delta, gamma, theta and vega.  Nothing too involved – after all this is just a blog – but a brief overview or refresher.  However, there is another greek that tends to get much less coverage – especially in the low interest rate environment we are in these days.  The greek I am referring to is known as Rho.  Rho measures the change in an option price given a 1% change in interest rates.  Options are leveraged instruments, that is they allow the holder to control a given amount of an underlying asset with less capital outlay than buying the underlying directly.  Leverage means borrowing costs are incurred, which are directly related to interest rates. Calls tend to rise as rates go up since calls require less capital to control a given amount of underlying.  That leverage advantage is priced into the option.  Puts tend to fall as rates rise as buying a put is a substitute for shorting stock.  However, owning a put does not allow the owner to collect a short stock rebate as shorting the stock would. This relative disadvantage is again priced into the option.  In-the-money options have higher rho than out of the money since they require more cash and hence are affected more by interest rate changes.   As you go further out in time, rho tends to go up as changes in interest rates have a bigger impact.  So there you have it.  The crib notes on rho.  You may now return to your leftovers, football game and nap.

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