General Securities Representative (Series 7) Practice Exam

What can affect the premium of an option besides the market value of the stock?

1. Interest rates

2. Company dividends

3. Both interest rates and volatility

4. Only stock performance

The correct answer is: Both interest rates and volatility

The premium of an option can be influenced by several factors beyond just the market value of the underlying stock. Among these factors, interest rates and the volatility of the underlying asset play significant roles. When interest rates rise, the cost of carrying an option position increases. Higher interest rates make it more attractive to hold stock rather than cash, as investors could earn more from interest. Consequently, this can lead to an increase in the option premium, particularly for call options. Volatility is another critical factor that affects option premiums. Options are often more valuable when the underlying asset exhibits high volatility because there is a greater chance that the option could expire in-the-money. The potential for price swings increases the likelihood of profit from exercising the option, so higher expected volatility typically leads to a higher premium. Company dividends also affect option pricing; however, they are factored into pricing models differently than interest rates and volatility. The presence of dividends can make call options less attractive and put options more valuable, but they do not have as direct a linear relationship with the premium as volatility and interest rates. Thus, recognizing that both interest rates and volatility are fundamental components influencing the premium of an option helps clarify why the response that includes both of these factors is the most appropriate answer.