If volatility increases, will the stock price increase?
No,but the option cost will!
will the stock price decrease?
No,but the option cost will increase.
The way I see it, higher volatility increases the risk on the stock, which in turn demands higher returns to carry that risk. Using a higher required return should decrease the discounted value of the company and thus decrease the price per share after dividing that value by the number of outstanding shares?
Good reasoning, but that will get you the wrong answer on the test.
Thanks man, where’d I go wrong?
Volatility means the stock can go down or go up in increased proportions. It’s neutral in direction. In a binomial tree, that would be ike an up movement of 1.5 and a down movement of 1.5. That’s why you can’t add an extra discount which would cause it to be mis-priced.
When volatility is high, options cost more. Right before an earnings call, volatility is highest. You could buy a call or you could buy a put and cross your fingers… Or you could take on a long straddle. You have no idea which direction the stock will go. Like netflix, it could go up 20% or down 20% after the earnings call.
Same reason why interest rate volatility will not change interest rate, but it will change the option embedded in the bond,