LOS k: Contrast American options with European options in terms of the lower bounds on option prices and the possibility of early exercise.

Q1. The value of an American option can equal that of a European option with the same maturity, exercise price, and underlying stock when:

A)   the owner of the American option chooses to exercise the option before maturity.

B)   the owner of the American option holds the option until maturity.

C)   the seller of the American option does not allow the holder to exercise before maturity.

Q2. Which of the following is least likely a valid reason to trade options?

A)   Options can be combined with stocks to perform like risk-free bonds.

B)   Option prices are more volatile than the underlying stock price.

C)   Exchange-traded options can be modified to exactly match the desired exposure to the underlying.

Q3. There are two different options available with ITM Corporation common stock as the underlying asset. They each have the same maturity date, a strike price of $40.00, and are identical in all other ways except, one is a European call, and the other is an American call. ITM stock has a market value of $43.75. The American call option is selling for $4.90. For the European call, which of the following option premiums is most likely?

A)   $4.90.

B)   $4.25.

C)   $5.25.

Q4. American options are worth no less than European options with the same maturity, exercise price, and underlying stock because:

A)   American options can be exercised before maturity, while European options can be exercised only at maturity.

B)   both of these choices are correct.

C)   purchasers of American options receive stock dividends, while purchasers of European options do not.

LOS k: Contrast American options with European options in terms of the lower bounds on option prices and the possibility of early exercise. fficeffice" />

Q1. The value of an American option can equal that of a European option with the same maturity, exercise price, and underlying stock when:

A)   the owner of the American option chooses to exercise the option before maturity.

B)   the owner of the American option holds the option until maturity.

C)   the seller of the American option does not allow the holder to exercise before maturity.

Correct answer is B)

If two options are identical (maturity, underlying stock, strike price, etc.) in all ways, except one is a European option and the other is an American option, the value of the American option will equal or exceed the value of the European option. Why? The American option has more flexibility than the European option, so it should be worth more. If you choose not to exercise the American option, it will be equal to the European option and have the same value. 

The other statements are false. Exercise is at the option of the holder, not the writer.

Q2. Which of the following is least likely a valid reason to trade options?

A)   Options can be combined with stocks to perform like risk-free bonds.

B)   Option prices are more volatile than the underlying stock price.

C)   Exchange-traded options can be modified to exactly match the desired exposure to the underlying.

Correct answer is C)       

Exchange-traded options are standardized to promote market liquidity. Since the contract terms cannot be modified, the exposure may or may not exactly match what is desired.

Q3. There are two different options available with ITM Corporation common stock as the underlying asset. They each have the same maturity date, a strike price of $40.00, and are identical in all other ways except, one is a European call, and the other is an American call. ITM stock has a market value of $43.75. The American call option is selling for $4.90. For the European call, which of the following option premiums is most likely?

A)   $4.90.

B)   $4.25.

C)   $5.25.

Correct answer is B)

Both the American and European calls have a strike price of $40.00. Each call is therefore in-the-money by $3.75 ($43.75 - $40.00). Since they are identical in all ways except when they can be exercised, and since European calls are less flexible than American, their market value, option premium, will most likely be lower. The lower option premium will allow for a higher return on the European option relative to the American, assuming both are held to expiration. This higher return is compensation for the reduced flexibility of the option terms.

Q4. American options are worth no less than European options with the same maturity, exercise price, and underlying stock because:

A)   American options can be exercised before maturity, while European options can be exercised only at maturity.

B)   both of these choices are correct.

C)   purchasers of American options receive stock dividends, while purchasers of European options do not.

Correct answer is A)

By definition.

thanks