Final answer:
Increases in the risk-free rate result in an increase in the value of call options and a decrease in the value of put options. For bonds, an increase in market interest rates leads to a decrease in the present value of future payments and thus the bond's market value.
Step-by-step explanation:
The question pertains to the effect of an increase in the risk-free rate on the value of call and put options. The value of a call option typically increases with an increase in the risk-free rate because the cost of carry is cheaper, making it more attractive to hold a call option rather than the underlying asset. Conversely, the value of a put option usually decreases because the future payout is discounted at a higher rate, making it less valuable.
Additionally, when we look at the bond market, an increase in the interest rate, from, for example, 8% to 11%, will not change the actual dollar payments, which are fixed based on the initial interest rate. However, it does decrease the present value of those future payments because they are discounted at a now higher interest rate. Consequently, the value of the bond will decrease if the holder tries to sell it, for it renders the bond less attractive compared to new issues with higher coupon rates.
When the risk-free rate increases, the value of a call option will decrease while the value of a put option will increase. This is because a higher risk-free rate reduces the present value of future cash flows, which in turn affects the value of options.