American Option

Spongebob

Which of the following statements about the early exercise of an option is least accurate? For an American:

A) call option, on an asset with no cash flows, early exercise can be profitable if the option is far in the money.
B) put option on an asset with no cash flows, early exercise is sometimes optimal.
C) call option on an asset with positive cash flows, early exercise is sometimes profitable.

Your answer: C was incorrect. The correct answer was A) call option, on an asset with no cash flows, early exercise can be profitable if the option is far in the money.
Early exercise of an American call option on an asset with no cash flows is never profitable, they are worth more ‘alive than dead’.

Q: Anyone can explain?

btcapital

That is sad , but good thing is you are already focused, know exactly what you want to do and the best part is, you are actually ahead of it

Beatnik

I'm afraid not because I am still an undergrad and not gonna grad until 2011



Edited 1 time(s). Last edit at Tuesday, October 27, 2009 at 06:17AM by revenant.

dece2011

My pleasure revenant. You are doing great! Keep up the hard work and good luck. I am sure we will be together for L2 in Jun.

kmf229

Yes, that is very much a possibility.

But in the question, when it says 'far' in the money, they want us to assume, it will remain in the money till the strike date.

mnieman

What if next weeks later it came out of money? It won't be profitable anymore.

manasib

If asset has positive cash flows then you might want to buy it earlier, because it will then start to give you those cashflows. In this case, you will consider if positive cashflows from it could compensate for the loss of interest you could earn on keeping your cash and buying the asset later.

But if asset does not have any positive cash flows then there is no such consideration.

amqata

I see.

A) call option, on an asset with no cash flows, early exercise can be profitable if the option is far in the money.
>> Since it is far in the money, can't I exercise it and sell the underlying immediately for a profit?

bapswarrior

I understand your comments, rus1bus.

I don't quite get the thing about "asset with no/positive CF". What is it trying to say? I only understand that if the asset has positive CF, the cost will be less by the PV of the CF.

Thanks.

joemoran

You are holding a call option, meaning you have right to buy, meaning if you exercise now you have to part with your cash now.

If option is deep in the money, then it is better to exercise it later rather than now. That way you get to keep your cash longer and earn discount rate on it.

Always, other things same, it is better to
a) buy later rather than sooner
b) and sell sooner rather than later

Hope this helps.