On specific exchanges, investors are permitted to short stock they do not own. In so doing, an investor borrows stock to subsequently short (i.e., selling it short). This process has its own costs which are embodied in the so-called ‘repo’. Repo, shortcut for ‘repurchase agreement’, involves a lender selling a stock with the agreement to purchase it back at a prespecified price on a future date. The lender always has the right to call the stock back.

Normally, the relationship between repo rates and the forward is one with negative correlation: as repo rises, the forward moves down, and vice versa. In essence, a repo rate is a very short-term interest rate and it can be used as a proxy for the riskless interest rate in the Black-Scholes model in order to determine, along with other factors, the value of an option contract. If the repo of an underlying stock sufficiently rises, call options lose value and put options gain value.

This relationship has to do with the way calls and puts are hedged. An investor with a long position in a call option can hedge his position by selling shares short. When market interest rates are high, hedging this position would cost more because it involves borrowing the stock at a high rate. Because the investor seeks to pay a specific level of implied volatility, he would need to find a call with a lower premium than that in an environment with much lower interest (repo) rates.

The opposite analysis holds in the case of a put option. An investor who has taken a long position in a put option will have to buy the underlying stock to hedge that position. If repo rates are high, the investor can lend these shares and earn extra income for the trade. In other words, the investor can pay a higher price for the option and still gain the same exposure (implied volatility) that can be attained when the underlying stock is held as general collateral.