Please could somebody explain to me why the value of an American option is equal to the value of a European option in the absence of cash flow in the underlying? Surely there is some value attached to the optionality to exercise early?
Yes there is some value attached to an American option when the underlying has cash flows.
-
Receiving the dividend has value. If the call is not exercised, then the investor foregoes the dividend.
-
After a dividend is paid, the value of the stock should theoretically decrease by the same amount as the dividend paid. A decrease in the value of the underlying would decrease your call value.
Without underlying cash flows, there’s rarely a reason to exercise an American option early: when you exercise the option you get only its intrinsic value, while if you sell it you get both the intrinsic value and the time value.
For very deep in-the-money put options, the time value can be negative; in that case, being able to exercise the option early is a benefit.
Do we also need to consider the TVM? If both options are deep in the money, having an American option that allow investor to exercise early is better than European option exercise at expiration. Is my thought correct?
That’s always a consideration. You’d need to compare the time value of money to the time value of the option.
Thanks all
I re-read the CFA notes and the key point (as S2000magician says) is that you’re always better off selling the option that exercising the option if you want to liquidate your position.