A Beginner's Guide to Crude Oil Options - Part IV - Interest Rates
As we discussed in A Beginner's Guide to Crude Oil Options - Part I Part II & Part III, there are four primary factors that determine the price of crude oil, as well as refined product, options:
- Prevailing price of the underlying future or swap relative to the strike price of the option
- Time value (also know as tenor or duration)
- Volatility
- Interest rates
Our last post focused on the third variable, volatility. Today we're going to address the fourth major component of the price of crude oil options, interest rates.
Interest rates impact the price of crude oil options as they represent the potential return that could be produced if the funds used to pay for an option were invested in an a "risk-free" instrument such as a US Treasury bill.
In practice, when market participants select the interest rate utilized to determine the price of a crude oil option, they generally use a "market accepted" benchmark interest rate for the respective tenor of the option. As an example, if you wanted to determine the appropriate interest rate for a crude oil option which expires in one year, you might choose to use the current rate for one year LIBOR.
To put this into numerical context, as of the close of business yesterday, a May 2014 $90 WTI crude oil put option settled at $6.31/BBL, which is based on an implied interest rate of 0.41%. As a comparison, if interest rates were to rise such that the interest rate utilized to determine the price of the May 2014 $90 WTI crude oil put option were 5%, rather than 0.41%, the value of the option would decline from $6.31 to $6.06. This is due to the fact that the value of the option declines as interest rates increase as higher interest rates lead to higher carrying costs.
For those of you interested in the more quantitative aspects of crude oil option prices, rho is the "Greek" variable associated with interest rates with respect to commodity option prices. Rho measures the sensitivity of an options value to a change in interest rates. As an example, if an option has a rho -10, then for every percentage-point increase in interest rates, the value of the option decreases by 10%.
In summary, while interest rates play an important role in the price of crude oil options, they are much less significant than the other major variables that we addressed in Parts I, II and III. As such, most market participants who are primarily concerned with hedging their commercial risk to crude oil prices, as opposed to crude oil option traders, should focus their option pricing efforts on the strike price, time to expiration and volatility.
UPDATE: This post is the fourth in a series on crude oil options. The previous posts can be found via the following links:
A Beginner's Guide to Crude Oil Options - Part I