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Sir I do not understand how increase in interest rates leads to increase in option value(premium)? the reason stated in my study text is that present value of future payment (strike price x lot size if call option exercised) is discounted more heavily hence making the strike price cheaper and eventual gain that much more significant. However my point is that even though the squaring off of the options takes place on the expiry, the upfront premium still has to be paid when both long calls and/or puts are bought. So if interest rates rise, long calls and puts become less affordable for those who borrow and pay the upfront premium. Hence the option value should fall, right?
Thanks as always!
Although it seems that you book explains it in a complicated way, what they getting at is the the last term in the Black Scholes formula is effectively discounting Pe on a continuous basis, as I explain in my lectures. If the interest rate increases then the PV of that last term in the equation will be lower, which will (ignoring all other factors) result in a higher option price.
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