Interview Question: Early Exercise

Sample Question #178 (finance – options)

Is it ever optimal to exercise an American call option before expiration? What about an American put option? Does the fact whether the stock pays dividends or not change your answer?

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2 Responses to Interview Question: Early Exercise

  1. Brett says:

    ANSWER
     
    The answer for the call does depend on whether the underlying stock pays dividends or not. Let’s assume it’s a non-dividend-paying stock. It’s never optimal to exercise early because you’d make more money by holding the in-the-money call and shorting an equivalent amount of stock, and investing the cash you receive at risk-free rate, than exercising the call and selling the stock you receive from the exercise. You can show this by calculating the interest you’d earn in each scenario; just note that for the scenario where you hold the call and short the stock, the call may or may not still be in-the-money at expiration date. You can do a simple binomial-tree calculation for the expiration.
     
    I’m not sure about the American put…  Anyone has an answer?
     

  2. says:

    we know that it can be optimal to exercise American put (without dividend) early, however, if there is dividend, the net loss of early exercise is increased by the present value of dividend, which means dividend delays early exercise or early exercise is less likely.

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