IFT Notes for Level I CFA® Program
R57 Basics of Derivative Pricing and Valuation
4.3. American Option Pricing
So far we looked at the payoff and valuation of European options. Now, we will discuss American options.
- The primary difference between the two is that American options can be exercised any time before expiration or exercise date. So, they are more valuable than European options since the holder can exercise the option before maturity date.
- Early exercise is not mandatory (required) so the right to exercise early cannot have a negative value.
- American options cannot sell for less than European options.
Some important points on American/European options:
- If there are no interim cash flows on the underlying asset before the call expires like dividends on stocks, then it is not prudent to exercise the option.
- American call prices can differ from European call prices only if there are cash flows on the underlying, such as dividends or interest; these cash flows are the only reason for early exercise of a call.
- American put prices can differ from European put prices, because the right to exercise early always has value for a put, which is because of a lower limit on the value of the underlying.
- If the underlying stock pays a dividend, then it is prudent for a put option holder not to exercise the option until its expiration. This ensures he receives the dividend on the stock.