Options prices are generally derived from a theoretical pricing model, the most commonly known being the Black-Scholes model. The major inputs to the model include the stock price, strike price, time to expiration and expected volatility. The model also takes into account a cost-of-carry component when pricing options.
The cost of carry represents the cost of owning or carrying an investment. For a stock, the cost of carry includes the interest rate (the cost of borrowing money to buy the stock), and any dividends the stock pays. The risk-free interest rate is used in the Black-Scholes model, which approximates the cost of money (or capital) over time. Dividends are the return of money to shareholders, which represents a cost to a call-option buyer and a benefit to a put-option buyer (as it creates a decline in the stock price).
In the Black-Scholes model, the cost of carry for any option will vary depending on the inputs, but the general pricing effect is outlined in the table below.
| Call | Put | |
|---|---|---|
| Interest Rates Increase | Price Increases | Price Decreases |
| Dividends Increase | Price Decreases | Price Increases |
The sensitivity of call and put prices to interest rate changes is captured by the greek "Rho". The sensitivity of call and put prices to dividends is typically called "Dividend Delta".