Which of the following statements is true in relation to an American style option:

Which of the following statements is true in relation to an American style option:

I. Put-call parity applies to American options

II. An American put will never be cheaper than a European put

III. An American put option should never be exercised early for a non-dividend paying stock

IV. An American put option is always at least as valuable as its intrinsic value
A . I, II and III
B . II and III
C . II and IV
D . III and IV

View Answer

Answer: C

Explanation:

The put-call parity applies to European options and does not hold for American options because the latter can be exercised at any time up to expiry. Therefore statement I is false. An American put can not be cheaper than a European put is correct. This is because the American put will always be valued at at least its intrinsic value whereas a European value may be valued at less than intrinsic value if the exercise date is too far away in the future. This is because a long time interval will increase the chance that the intrinsic value may not be realized at expiry. Because the American put can be exercised anytime, it will always be at least equal to its intrinsic value because if it were to be cheaper than that, investors would immediately buy and exercise it, creating a riskless profit. Therefore statement II is correct, and statement IV is correct as well.

It may be optimal to exercise an American put (unlike an American call – note the difference!) before its expiry on a non dividend paying stock. This would be the case only when the put is deep in the money. If the option is really deep in the money (say, when the underlying’s price is down to zero), then it may be worthwhile to cash the option out prior to expiry as the upside might be lost if time were to be allowed to pass. Additionally, any further upside in the case of a deep in the money option may be zero or very little, and the time value of money would also make immediate exercise prefereable. Therefore statement III is not correct.