American Options: An Undergraduate Introduction To Financial Mathematics

American Options
An Undergraduate Introduction to Financial Mathematics

J. Robert Buchanan
2010
J. Robert Buchanan American Options
Early Exercise
Since American style options give the holder the same rights as
European style options plus the possibility of early exercise we
know that
C
e
C
a
and P
e
P
a
.
Early Exercise
An American option (a call, for instance) may have a positive
payoff even when the corresponding European call has zero
payoff.
T
t
K
St
Trade-offs of Early Exercise
Consider an American-style call option on a dividend-paying
stock. If the option is exercised early you,
own the stock and are entitled to receive any dividends
paid after exercise,
pay the strike price K early foregoing the interest
K
_
e
r (Tt)
1
_
you could have earned on it, and
pay the strike price K early foregoing the interest
K
_
e
r (Tt)
1
_
you could have earned on it, and
lose the insurance provided by the call in case S(T) < K.
Parity
Recall: European options obey the Put-Call Parity Formula:
P
e
+S = C
e
+ Ke
rT
Parity
P
e
+S = C
e
+ Ke
rT
American options do not satisfy a parity formula, but some
inequalities must be satised.
Parity
P
e
+S = C
e
+ Ke
rT
American options do not satisfy a parity formula, but some
inequalities must be satised.
Theorem
Suppose the current value of a security is S, the risk-free
interest rate is r , and C
a
and P
a
are the values of an American
call and put respectively on the security with strike price K and
expiry T > 0. Then
C
a
+ K S + P
a
Proof
Assume to the contrary that C
a
+K < S + P
a
.
Sell the security, sell the put, and buy the call. This
produces a cash ow of S + P
a
C
a
.
Invest this amount at the risk-free rate,
If the owner of the American put chooses to exercise it at
time 0 t T, the call option can be exercised to
purchase the security for K.
The net balance of the investment is
(S + P
a
C
a
)e
rt
K > Ke
rt
K 0.
If the American put expires out of the money, exercise the
call to close the short position in the security at time T.
The net balance of the investment is
(S + P
a
C
a
)e
rT
K > Ke
rT
K > 0.
Thus the investor receives a non-negative prot in either case,
violating the principle of no arbitrage.
Another Inequality
Theorem
Suppose the current value of a security is S, the risk-free
interest rate is r , and C
a
and P
a
are the values of an American
call and put respectively on the security with strike price K and
expiry T > 0. Then
S + P
a
C
a
+ Ke
rT
Proof
Suppose S + P
a
< C
a
+ Ke
rT
.
Sell an American call and buy the security and the
American put. Thus C
a
S P
a
is borrowed at t = 0.
If the owner of the call decides to exercise it at any time
0 t T, sell the security for the strike price K by
exercising the put. The amount of loan to be repaid is
(C
a
S P
a
)e
rt
and
(C
a
S P
a
)e
rt
+ K = (C
a
+Ke
rt
S P
a
)e
rt
(C
a
+Ke
rT
S P
a
)e
rt
since r > 0. By assumption S + P
a
< C
a
+ Ke
rT
, so the
last expression above is positive.
Combination of Inequalities
Combining the results of the last two theorems we have the
following inequality.
S K C
a
P
a
S Ke
rT
Example
Example
The price is a security is currently $36, the risk-free interest
rate is 5.5% compounded continuously, and the strike price of a
six-month American call option worth $2.03 is $37. The range
of no arbitrage values of a six-month American put on the same
security with the same strike price is
S K C
a
P
a
S Ke
rT
Example
Example
S K C
a
P
a
S Ke
rT
36 37 2.03 P
a
36 37e
0.055(6/12)
Example
Example
S K C
a
P
a
S Ke
rT
36 37 2.03 P
a
36 37e
0.055(6/12)
2.03 P
a
3.03
A Surprising Equality
We know C
a
C
e
, but in fact:
We know C
a
C
e
, but in fact:
Theorem
If C
a
and C
e
are the values of American and European call
options respectively on the same underlying
non-dividend-paying security with identical strike prices and
expiry times, then
C
a
= C
e
.
We know C
a
C
e
, but in fact:
Theorem
If C
a
and C
e
are the values of American and European call
options respectively on the same underlying
non-dividend-paying security with identical strike prices and
expiry times, then
C
a
= C
e
.
Remark: American calls on non-dividend-paying stocks are not
exercised early.
Proof
Suppose that C
a
> C
e
.
Sell the American call and buy a European call with the
same strike price K, expiry date T, and underlying
security. The net cash ow C
a
C
e
> 0 would be invested
at the risk-free rate r .
If the owner of the American call chooses to exercise the
option at some time t T, sell short a share of the security
for amount K and add the proceeds to the amount invested
at the risk-free rate.
At time T close out the short position in the security by
exercising the European option. The amount due is
(C
a
C
e
)e
rT
+ K(e
r (Tt)
1) > 0.
If the American option is not exercised, the European
option can be allowed to expire and the amount due is
(C
a
C
e
)e
rT
> 0.
American Puts
Theorem
For a non-dividend-paying stock whose current price is S and
for which the American put with a strike price of K and expiry T
has a value of P
a
, satises the inequality
(K S)
+
P
a
< K.
Proof
Suppose P
a
< K S.
Buy the put and the stock (cost P
a
+ S).
Immediately exercise the put and sell the stock for K.
Net transaction K P
a
S > 0 (arbitrage).
Proof
Suppose P
a
< K S.
Buy the put and the stock (cost P
a
+ S).
Immediately exercise the put and sell the stock for K.
Net transaction K P
a
S > 0 (arbitrage).
Suppose P
a
> K.
Sell the put and invest proceeds at risk-free rate r . Amount
due at time t is P
a
e
rt
.
If the owner of the put chooses to exercise it, buy the stock
for K and sell it for S(t). Net transaction
S(t) K + P
a
e
rt
> S(t) + K(e
rt
1) > 0.
If the put expires unused, the prot is P
a
e
rT
> 0.
Example
Remark: in contrast to American calls, American puts on
non-dividend-paying stocks will sometimes be exercised early.
Example
Consider a 12-month American put on a non-dividend paying
stock currently worth $15. If the risk-free interest rate is 3.25%
per year and the strike price of the put is $470, should the
option be exercised early?
Solution
We were not told the price of the put, but we know
P
a
< K = 470.
If we exercise the put immediately, we gain 470 15 = 455
and invest at the risk-free rate.
In one year the amount due is
455e
0.0325
= 470.03 > K > P
a
.
Thus the option should be exercised early.
American Calls
Theorem
For a non-dividend-paying stock whose current price is S and
for which the American call with a strike price of K and expiry T
has a value of C
a
, satises the inequality
(S Ke
rT
)
+
C
a
< S.
Variables Determining Values of American Options (1
of 3)
Theorem
Suppose T
1
< T
2
and
let C
a
(T
i
) be the value of an American call with expiry T
i
,
and
let P
a
(T
i
) be the value of an American put with expiry T
i
,
then
C
a
(T
1
) C
a
(T
2
)
P
a
(T
1
) P
a
(T
2
).
Proof
Suppose C
a
(T
1
) > C
a
(T
2
).
Buy the option C
a
(T
2
) and sell the option C
a
(T
1
). Initial
transaction,
C
a
(T
1
) > C
a
(T
2
) > 0
If the owner of C
a
(T
1
) chooses to exercise the option, we
can exercise the option C
a
(T
2
). Transaction cost,
(S(t ) K) (S(t ) K) = 0.
Since we keep the initial transaction prot, arbitrage is present.
of 3)
Theorem
Suppose K
1
< K
2
and
let C
a
(K
i
) be the value of an American call with strike price
K
i
, and
let P
a
(K
i
) be the value of an American put with strike price
K
i
,
then
C
a
(K
2
) C
a
(K
1
)
P
a
(K
1
) P
a
(K
2
)
C
a
(K
1
) C
a
(K
2
) K
2
K
1
P
a
(K
2
) P
a
(K
1
) K
2
K
1
.
of 3)
Theorem
Suppose S
1
< S
2
and
let C
a
(S
i
) be the value of an American call written on a
stock whose value is S
i
, and
let P
a
(S
i
) be the value of an American put written on a
stock whose value is S
i
,
then
C
a
(S
1
) C
a
(S
2
)
P
a
(S
2
) P
a
(S
1
)
C
a
(S
2
) C
a
(S
1
) S
2
S
1
P
a
(S
1
) P
a
(S
2
) S
2
S
1
.
Proof (1 of 3)
Suppose C
a
(S
1
) > C
a
(S
2
).
Proof (1 of 3)
Suppose C
a
(S
1
) > C
a
(S
2
). Ordinarily we would argue to
purchase the call C
a
(S
2
) and sell the call C
a
(S
1
); however,
Proof (1 of 3)
Suppose C
a
(S
1
) > C
a
(S
2
purchase the call C
a
(S
2
a
(S
1
); however, the
stock has only one price for all buyers and sellers, initially S(0).
Proof (1 of 3)
Suppose C
a
(S
1
) > C
a
(S
2
purchase the call C
a
(S
2
a
(S
1
); however, the
stock has only one price for all buyers and sellers, initially S(0).
Dene x
1
=
S
1
S(0)
and x
2
=
S
2
S(0)
.
Proof (2 of 3)
Sell x
1
options C
a
(S(0)) where
x
1
C
a
(S(0)) = C
a
(S
1
)
and buy x
2
options C
a
(S(0)) where
x
2
C
a
(S(0)) = C
a
(S
2
).
Initial transaction is
C
a
(S
1
) C
a
(S
2
) > 0.
If the owner of option C
a
(S
1
) chooses to exercise it, option
C
a
(S
2
) is exercised as well. Transaction prot is
x
2
(S(t ) K) x
1
(S(t ) K) = (x
2
x
1
)(S(t ) K) > 0.
Arbitrage is present.
Proof (3 of 3)
Suppose P
a
(S
1
) P
a
(S
2
) > S
2
S
1
, this is equivalent to the
inequality
P
a
(S
1
) + S
1
> P
a
(S
2
) + S
2
.
Buy x
2
put options P
a
(S(0)), sell x
1
put options P
a
(S(0)),
and buy x
2
x
1
shares of stock. Initial transaction,
x
1
P
a
(S(0)) x
2
P
a
(S(0)) (x
2
x
1
)S(0)
= P
a
(S
1
) P
a
(S
2
) (S
2
S
1
) > 0.
If the owner of put P
a
(S
1
) chooses to exercise the option,
we exercise put P
a
(S
2
) and sell our x
2
x
1
shares of stock.
(x
2
x
1
)S(t )+x
2
(K S(t ))x
1
(K S(t )) = (x
2
x
1
)K > 0
Arbitrage is present.
Binomial Pricing of American Puts
Assumptions:
Strike price of the American put is K,
Expiry date of the American put is T > 0,
Price of the security at time t with 0 t T is S(t ),
Continuously compounded risk-free interest rate is r , and
Price of the security follows a geometric Brownian motion
with variance
2
.
Denitions
u: factor by which the stock price may increase
during a time step.
u = e
t
> 1
d: factor by which the stock price may decrease
during a time step.
0 < d = e
t
< 1
p: probability of an increase in stock price during a
time step.
0 < p =
1
2
_
1 +
_
r
2
_
t
_
< 1
Illustration
S0
STu S0
p
1p
STd S0
Intrinsic Value
Observation: an American put is always worth at least as
much as the payoff generated by immediate exercise.
Denition
The intrinsic value at time t of an American put is the quantity
(K S(t ))
+
.
Intrinsic Value
Observation: an American put is always worth at least as
much as the payoff generated by immediate exercise.
Denition
The intrinsic value at time t of an American put is the quantity
(K S(t ))
+
.
The value of an American put is the greater of its intrinsic value
and the present value of its expected intrinsic value at the next
time step.
One-Step Illustration (1 of 2)
KS0
Ku S0
Kd S0

At expiry the American put is worth
P
a
(T) =
_
(K uS(0))
+
with probability p,
(K dS(0))
+
with probability 1 p.
At expiry the American put is worth
P
a
(T) =
_
(K uS(0))
+
with probability p,
(K dS(0))
+
with probability 1 p.
At t = 0 the American put is worth
P
a
(0) = max
_
(K S(0))
+
,
e
rT
_
p(K uS(0))
+
+ (1 p)(K dS(0))
+
_
= max
_
(K S(0))
+
, e
rT
E
_
(K S(T))
+
_
= max
_
(K S(0))
+
, e
rT
E[P
a
(T)]
_
.
Two-Step Ilustration (1 of 2)
KS0
Ku S0
Kd S0
Ku
2
S0
Ku d S0
Kd
2
S0

At t = T/2, if the put has not been exercised already, an
investor will exercise it, if the option is worth more than the
present value of the expected value at t = T.
P
a
(T/2) = max
_
(K S(T/2))
+
, e
rT/2
E[P
a
(T)]
_
At t = T/2, if the put has not been exercised already, an
investor will exercise it, if the option is worth more than the
present value of the expected value at t = T.
P
a
(T/2) = max
_
(K S(T/2))
+
, e
rT/2
E[P
a
(T)]
_
Using the same logic, the value of the put at t = 0 is the larger
of the intrisic value at t = 0 and the present value of the
expected value at t = T/2.
P
a
(0) = max
_
(K S(0))
+
, e
rT/2
E[P
a
(T/2)]
_
Example
Example
Suppose the current price of a security is $32, the risk-free
interest rate is 10% compounded continuously, and the volatility
of Brownian motion for the security is 20%. Find the price of a
two-month American put with a strike price of $34 on the
security.
Example
Example
Suppose the current price of a security is $32, the risk-free
interest rate is 10% compounded continuously, and the volatility
of Brownian motion for the security is 20%. Find the price of a
two-month American put with a strike price of $34 on the
security.
We will set t = 1/12, then
u 1.0594
d 0.9439
p 0.5574.
Stock Price Lattice
32.
33.9019
30.2048
35.9168
32.
28.5103
Intrinsic Value Lattice
2.
0.0981044
3.7952
0
2.
5.48969
Pricing the Put at t = 1/12
If S(1/12) = 33.9019 then
P
a
(1/12) = max
_
(34 33.9019)
+
,
e
0.10/12
(0.5574(34 35.9168)
+
+ (1 0.5574)(34 32)
+
)
_
= 0.8779.
If S(1/12) = 30.2048 then
P
a
(1/12) = max
_
(34 30.2048)
+
,
e
0.10/12
(0.5574(34 32)
+
+ (1 0.5574)(34 28.5103)
+
)
_
= 3.7942.
Pricing the Put at t = 0
P
a
(0) = max
_
(34 32)
+
,
e
0.10/12
[(0.5574)(0.8779) + (0.4426)(3.7952)]
_
= 2.1513.
American Put Lattice
2.15125
0.877945
3.7952
0
2.
5.48969
Summary:
_
_
P
a
(t )
(K S(t ))
+
S(t )
_
_
2.15125
2.
32.
0.877945
0.0981044
33.9019
3.7952
3.7952
30.2048
0
0
35.9168
2.
2.
32.
5.48969
5.48969
28.5103
General Pricing Framework
Using a recursive procedure, the value of an American option,
for example a put, is given by
P
a
(T) = (K S(T))
+
P
a
((n 1)t ) = max
_
(K S((n 1)t ))
+
, e
r t
E[P
a
(T)]
_
P
a
((n 2)t ) = max
_
(K S((n 2)t ))
+
,
e
r t
E[P
a
((n 1)T)]
_
.
.
.
P
a
(0) = max
_
(K S(0))
+
, e
r t
E[P
a
(T)]
_
.
Early Exercise for American Calls
If a stock pays a dividend during the life of an American call
option, it may be advantageous to exercise the call early so as
to collect the dividend.
Example
Suppose a stock is currently worth $150 and has a volatility of
25% per year. The stock will pay a dividend of $15 in two
months. The risk-free interest rate is 3.25%. Find the prices of
two-month European and American call options on the stock
with strikes prices of $150.
Solution (1 of 3)
If t = 1/12, then
u = e
t
1.07484
d = e
t
0.930374
p =
1
2
_
1 +
_
r
2
_
t
_
0.500722.
Solution (2 of 3) Stock Prices
150
161.226
139.556
158.291
135.
114.839
Solution (3 of 3) Call Prices
1.93942
5.60565
4.00998
11.2255
0
0
8.2911
8.2911
0
0
0
0

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An Undergraduate Introduction to Financial Mathematics

J. Robert Buchanan American Options

J. Robert Buchanan American Options

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