American options

Definition

American options are financial derivatives that allow the holder to exercise the option at any time before or on its expiration date. This flexibility makes them distinct from European options, which can only be exercised at expiration. The ability to exercise early can be valuable, particularly in contexts such as dividends and interest rates, and it connects deeply with various valuation methods and models.

5 Must Know Facts For Your Next Test

1. American options offer more strategic opportunities for traders due to their early exercise feature, which can lead to higher premiums compared to European options.
2. The valuation of American options is more complex than European options because they can be exercised at multiple points in time, requiring advanced pricing models.
3. Dividends are a crucial consideration for American options; holders may choose to exercise the option early to capture dividend payments from the underlying asset.
4. In a binomial option pricing model, American options can be priced using a backward induction approach, considering optimal exercise at each step.
5. The Black-Scholes model primarily addresses European options; however, adjustments must be made when applying it to American options due to their unique exercise characteristics.

Review Questions

• How does the flexibility of American options impact their valuation compared to European options?
  • The flexibility of American options allows them to be exercised at any time up until expiration, leading to a wider range of potential payoffs. This flexibility increases their intrinsic value, as traders can react to market conditions more dynamically. In contrast, European options are limited to exercise only at expiration, which typically results in lower premiums for European options when compared to American options.
• Discuss how dividends influence the decision to exercise American options early.
  • Dividends can play a significant role in the decision-making process regarding the early exercise of American options. If a stock is expected to pay a dividend before the expiration of an option, it may be advantageous for the holder of an American call option to exercise early in order to receive the dividend payment. This consideration adds another layer to the valuation and timing strategy associated with American options, as capturing dividends can enhance overall returns.
• Evaluate the advantages and disadvantages of using binomial trees for pricing American options compared to other methods.
  • Using binomial trees for pricing American options offers several advantages, such as providing a clear framework for assessing multiple exercise points and adapting to changes in volatility or interest rates throughout the life of the option. However, this method can become computationally intensive with increased complexity and multiple time steps. In contrast, while analytical methods like the Black-Scholes model may provide quicker estimates, they often lack accuracy for American options due to their inability to accommodate early exercise effectively. Therefore, while binomial trees present a flexible approach for valuation, they also require careful consideration regarding computational resources and model setup.

Related terms

European options:

A type of financial option that can only be exercised at the expiration date, limiting the holder's flexibility compared to American options.

Payoff structure: The profile of potential returns from an option, influenced by factors like the underlying asset's price movement and the specific terms of the option.

Volatility:

A statistical measure of the dispersion of returns for an asset, which significantly impacts option pricing and decision-making for exercising options.