Hi all,
I was looking at option prices which incorporate stochastic interest rates, as in the following paper - formulas 4 and 5 on p.9:
http://www3.nccu.edu.tw/~liaosl/Publication/28.pdf
So looking at the adjusted volatility term, the higher the correlation between stock returns and bond returns (i.e. rho is close 1 and the stock is "bond-like"), the lower the variance and correspondingly, the lower the option price. Conversely, if rho is close to 0 and stock returns and bond returns are uncorrelated, keeping everything else equal, option prices will be higher.
Why does that make sense? For instance, a company which can respond to inflation quickly by pushing costs to customers should have lower correlation with interest rates. Why would that make an option issued by this company more expensive - shouldn't it be the opposite? Thanks all!