This lesson is part 2 of 6 in the course Option Valuation Lower Bound We know that the value of an option is equal to the sum of its intrinsic value and time value. Since an option cannot sell below its intrinsic value, its value cannot be negative, Therefore, the lower bound for both American and European options is zero. Upper Bound Call Options A call option provides the option buyer the right to buy the asset. For the option to have value, its price at any time must be lower than the underlying stock price at any time. This is because if the option price were higher than the stock price, it would be cheaper to just buy the asset directly in the spot market.
European Options differ from American options in the sense that American option holders have the liberty of exercising the option anytime, be it on or before the expiration date. Investors of such options can, however, choose to sell their holdings in the market before the expiration date approaches.
Under such circumstances, profit is essentially the difference option value on euro the premium earned and the premium paid. Also, European and American options are mutually exclusive in the market. Both these options basically differ on three grounds: European options Can be exercised only at its expiration date Can be exercised anytime during the life of the option Traded over the counter Generally, have a lower upfront cost, i.
A Real Options Perspective on the Future of the Euro
Have higher premiums Can have stocks and foreign currencies as the underlying Can have stocks, bondscommodities, and option value on euro as the underlying security Advantages There is a predetermined time of expiration of the contract that gives the investor some certainty.
These options are less expensive than American options.
Due to the added flexibility of any time exercise in American options, the upfront cost tends to be higher than European options. This tends to be less risky, and the pricing complexity is also less due to the availability of limited options of contract execution.
They can be subject to other types of unique risks. A meticulous approach has to be adopted in order to avoid such risks.
One such risk is the trading lapse risk. Trading of European options closes at the end of the business day on a Thursday that falls before the third Friday of the expiration month. This can lead to an unexpected change in the price of the underlying.
The settlement price might be a little tricky to determine due to the trading lapse risk. The BSM model used for pricing might not be the most accurate model due to some unreal assumptions involved in the calculation.
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The pricing model makes certain assumptions of dividendvolatility, and risk-free rate being constant during the entire duration, which is unreal, and hence prices might be different from the real world.
Conclusion The naming of European and American options has nothing to do with the respective geographical locations.
In other words, if the underlying security such as a stock has moved in price an investor would not be able to exercise the option early and take delivery of or sell the shares. Instead, the call or put action will only take place on the date of option maturity. Another version of the options contract is the American options, which can be exercised any time up to and including the date of expiration. The names of these two versions should not be confused with the geographic location as the name only signifies the right of execution.
It simply gives an idea of when an option can be exercised. A majority of options traded in the US are known to be European options.
Effect of the value of the underlying: The call option can be viewed as buying the underlying and the put option can be viewed as selling the underlying. So, the value of call option increases with an increase in the value of the underlying and the value of put option decreases with an increase in the value of the underlying. Effect of the exercise price: The lower is the exercise price, the higher will be the value of the call option because we would be able to buy the underlying at a lower price.
Due to the difference in the features of the two options, investor expectations also vary. Like, an American option holder would expect the prices to move favorably before the expiration date arrives.
Here we discuss the formula to calculate the Price of the European Call and Put option along with practical examples, advantages, and disadvantages.
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