What factor increases the option values in interest rate options?

Higher volatility of interest rates is a crucial factor that increases the values of interest rate options. This is because options derive their value from the uncertainty of future movements in interest rates; the greater the potential for fluctuation, the more valuable the option becomes.

When volatility increases, the likelihood that the underlying interest rate will move significantly—either up or down—also rises. This potential for larger price swings increases the chance that the option will become profitable at expiration. Consequently, traders are willing to pay a higher premium for options when they expect larger swings in interest rates, reflecting the increased potential for profit.

In contrast, lower volatility leads to a decreased range of potential outcomes, which diminishes the potential for the option to be profitable. Shorter time to maturity generally reduces the time available for the underlying asset to move significantly, thereby decreasing the option's time value. A fixed risk-free rate does not directly influence the volatility aspect, but rather sets a baseline for pricing options. Therefore, while all other factors may influence option pricing, it is specifically the higher volatility of interest rates that directly boosts the value of interest rate options.