Pricing models: interest rate

[iwtlib]

What value of "risk-free" interest rate should one use in option pricing models such as Black-Scholes? Fed rate(~2%)? 10-year US treasury note (~4.13%), 30 year US treasury note (~4.59%). Thanks for your comments.

 

[Profitaker]

iwtlib

Strictly speaking I don’t think there is such a thing as a “Risk free” rate, but government treasury bills must come as close as you can ever get, certainly less risky than a bank deposit. As for a time frame, I would suggest looking at bills which expire closest to that of the expiry date of option you’re trying to value. Even then, the yield on the bill will be changing, when the BS model assumes a constant interest rate over the life of the option - so clearly a contradiction there.

But don’t worry… of all the inputs into the BS model, slight differences in interest rates affect the option valuation least of all, especially with near-time options.

 

[Robertral]

iwtlib

Strictly speaking I don’t think there is such a thing as a “Risk free” rate, but government treasury bills must come as close as you can ever get, certainly less risky than a bank deposit. As for a time frame, I would suggest looking at bills which expire closest to that of the expiry date of option you’re trying to value. Even then, the yield on the bill will be changing, when the BS model assumes a constant interest rate over the life of the option - so clearly a contradiction there.

But don’t worry… of all the inputs into the BS model, slight differences in interest rates affect the option valuation least of all, especially with near-time options.

Welcome Profittaker....exactly what I was going to say.....

 

[iwtlib]

Thanks for the comments. I've noticed this when plotting the effects of the different parameters in excel. The others are more readily defined (strike, underlying price, volatility, time til expiry). I wanted to nail the interest rate down. Thanks again.