Thursday, July 12, 2012

Q: when is rho important

A: long-dated options.

I was told for both equity options and currency options, rho is usually the least significant price sensitivity greek.

For a customized "structured" option, maturity could be 10 years or longer. I feel the BS assumption of a constant risk-free rate breaks down -- Over 10 years, interest rate could quadruple. Stock price could be directly affected even if all other factors remain constant. Implied vol could also be affected. However, to compute theoretical rho, we need to hold all of them constant and simulate a small bump in the time-invariant interest rate. In that context, over 10 years the effect on option valuation is non-negligible.

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