Is the same as a European option in case of no cashflows on the underlying stock?
This is Schweser practice exams 2013 Exam 2 Vol. 1 Q 40.
Wow… good question…
I thought American option is always more valuable than European since you have option to excerise it earlier.
I thought the same as well, Schweser has something else in mind apparently.
Schweser is right
In order to exercise a call and a put you need certain conditions to be satisfied for it to be worth it. For calls, it’s if dividend is enough to exercise it (but you exercise it the day before the stock is supposed to go ex-div), for puts its the interest rate - if interest rates are high enough and american put is sufficiently in the money, you exercise it immediately (and invest at the risk free rate of interest).
So in essence, if your american option has no dividends, then there is no upside for an options trader to exercise his options before the expiry - hence, the advantage he has over EU options will be negated and US = EU option in that case
PS: Don’t worry about this too much, I doubt anyone who doesn’t deal with options at work or studied at Uni would know so probably won’t be tested
I haven’t looked at the American style binomial valuation. Does this mean that both should give you the same call price for two period options? (If we assume the investor exercises in-the-money at all times)
There is no advantage in exercising an american option prior to expiration if there are no underlying cash flows (such as dividends), hence american option value = european option value in that specific case.
First, only American puts are exercised on the condition of being sufficiently in the money and IR being high enough.
Second, the model doesn’t matter - when the only edge one style of option has over the other is eliminated, it’s priced the same - whichever model you choose, assuming same underlying model assumptions of course
You’re probably getting confused because (maybe, and I’m just guessing) you’re ignoring that whilst you can’t exercise EU options prior to expiry, it’s also gaining value as the underlying is going in favour (as is US option).
Both change the same, the only diff is in underlying cashflows
I guess you’re right. I always assumed that the right to exercise early required some sort of premium to lock-in profits in case there was favorable volatility prior to maturity. But BSM assumes constant volatility of returns in this case.
Thanks.
Well, here we are probably talking about Option on Stock. In Schweser Book, Practice Problems - Derivatives, Question 15, American option has higher value than European Option under the bionimial framework. Both Options has all the same assumptions (except obviously you can exercise before!)
See but say I bought an American Call option on a stock with an exercise price of $20… Over some time i think the stock has become overvalued and its trading at $30, so i exercise the option, buy at $20 and sell it right after at $30. Then the stock then goes back down to $25 by time the Euro option would have reached expiration… I made $10 instead of $5 by having an American call option instead of a Euro option so doesn’t that make the American call more valuable? … Or am I an idiot and looking at this all wrong?
I’ll be precise-
Consider, you bought an ATM call on a stock for $x, next day the stock doubles.
Whether you hold a US or EU option, you can sell this option back in the market at an increased price to pocket the move up in stock. It makes no diff whatsoever whether you can exercise or not, the option is worth more now and if you call a dealer - he’ll give you a bid which accounts for this increase.
The only difference comes in when the underlying has a cashflow which you can’t receive because you’re synthetically long on the underlying (and not actually holding the underlying instrucment which has a cashflow, i.e. don’t have the right to receive one)
Can you please respond to one of my post on Currency Forward. Thanks in advance.
http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91343151
got it… thanks for the explanation.