The Layman's Guide to Natural Gas Options - Part IV

As we discussed in our last post, The Layman's Guide to Natural Gas Options - Part III, there are four primary variables that affect the premium or price of natural gas, as well as crude oil, heating oil and gasoline, options:

• The prevailing price of the underlying natural gas swap relative to the strike price of the option
• The time remaining until the option expires
• Price volatility of the underlying natural gas swap
• Interest rates

Our last post focused on the third variable, volatility. Today we're going to address the fourth major component of the price of natural gas options, interest rates.

Interest rates have a bearing on the price of natural gas options as they represent the potential return that could be produced if the funds used to pay for an option were invested in an a "risk-free" instrument such as U.S. Treasury bills.  In practice isolating the impact of a change in interest rates on the price of natural gas options is a difficult task as as a change in interest rates influences the net present value of an option as well as the cost of buying and storing natural gas and even the underlying price of natural gas (or any other energy commodity).  In short, while interest rates play an important role in the price of natural gas options, they are less significant than the other major variables that we've addressed in Parts I, II and III.  As such, most natural gas producers, marketers and consumers concerned with hedging and risk management, should focus their option pricing efforts on the strike price vs. the price of the underlying natural gas swap, the time to expiration and volatility.

UPDATE: This post is the first in a series on natural gas options.  The previous posts can be found via the following links:

The Layman's Guide to Natural Gas Options - Part I - Price

The Layman's Guide to Natural Gas Options - Part II - Time Value

The Layman's Guide to Natural Gas Options-Part III - Volatility