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ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions

A company holds a European call and a European put on the same non-dividend-paying share, with the same exercise price and expiry date. Other things equal, what happens to the values of the two options if the expected volatility of the share price rises?

Both the call and the put increase in value. Greater volatility raises the chance of large favourable price moves, while the holder's loss is capped at the premium. This makes both European calls and puts more valuable, unlike changes in share price or interest rates, which move them in opposite directions.

  1. ABoth the call and the put increase in valueCorrect
  2. BThe call increases in value and the put decreases in value
  3. CThe call decreases in value and the put increases in value
  4. DNeither changes, because volatility affects only the time value of American options

Explanation

Higher volatility widens the range of possible share prices at expiry. Because an option's downside is limited to the premium paid while its upside is not, both calls and puts gain value. Option 2 confuses volatility with the effect of a change in the share price or interest rate, which do move calls and puts in opposite directions.

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