Pricing American Options

Dilip Madan
Department of Finance
Robert H. Smith School of Business
American Call Options
We have seen as a consequence of call lower bounds
that in the absence of dividends there is no early
exercise for an American call option.

We now consider early exercise in the presence of a

…xed dividend of dt dollars at time t < T the option
maturity.

After time t the stock has no dividends and there

will be no early exercise.

One may seek to exercise before the dividend date if

the dividend is large enough.

To determine how large we compare the cash ‡ow on

exercise predividend to what one has post dividend.
Time Value of Call Option
with no dividends
In this regard it is useful to de…ne the time value of
an option with no dividends.

The time value of an option is the excess of the

value of the option over giving up the option and
commiting to exercise now.

The latter is the value of a forward contract.

Hence

T V C (t) = C (S (t); t; K; T )
(S (t) KB (t; T ))
C (S (t); t; K; T ) = S (t) KB (t; T ) + T V C (t)
 Time Value of Call
25

Time Value
20 Value of Forward
Call Pay off

15

Call Value
10

5
Values

-5

-10

-15

-20
80 85 90 95 100 105 110 115 120
Stoc k Pric e

Figure 1: Time Value of Call Option

We present a graph of this time value function

As may be observed this time value is always strictly

positive as it exceeds the gap between the forward
and the payo¤ for large values of the spot.

We now recognize that prior to the dividend the

stock price is a cum dividend price that we write as
S c(t) while after t we have ex-dividend price written
as S e(t) with the relation at t of

S c(t) = S e(t) + dt:

If we exercise predividend we receive the value

S c(t) K

If we fail to exercise we have the value

C (S e(t); t; K; T )

We now note that

S c(t) K = S e(t) + dt K

while

C (S e(t); t; K; T ) = S e(t) KB (t; T ) + T V C (t)

Early exercise is then called for when

dt > K (1 B (t; T )) + T V C (t)

The dividend must be large enough to compensate

for interest lost on early payment of strike plus loss
of time value on option.

If interest rates are low and the spot is high the right
hand side is small and early exercise gets more likely
for any given dividend.
American Put Options
We consider put options exercise with no dividends
and then with dividends.

The time value of a put option is the excess of the

put value over the value of commiting to exercise
now.

The latter is the forward sale for the strike.

Hence

T V P (t) = P (S (t); t; K; T )
(KB (t; T ) S (t))
P (S (t); t; K; T ) = KB (t; T ) S (t) + T V P (t)

We present a graph of the time value for a European

put option.
 Time Value of Put
50

40 Put Pay off Time Value of Put

Put Value
30

20
Values

10

-10

-20 Value of Forward

-30
50 60 70 80 90 100 110 120
Stoc k Pric e

For low values of the spot time value vanishes making

exercise likely especially if rates are high and the gap
between payo¤ and European put value is high.

If we exercise we receive the value

K S (t)

If we hold the option we have

P (S (t); t; K; T ) = KB (t; T ) S (t) + T V P (t)

So we exercise if

K (1 B (t; T )) > T V P (t)

or the interest earned on the early receipt of the strike

dominates the time value of the put option.

In the presence of dividends in the interim at say

time u; t < u < T in the amount du the value of
the forward changes to the present value of the strike
less the value of the forward stock or

KB (t; T ) (S (t) duB (t; u))

The exercise condition is revised to

K (1 B (t; T )) > T V P (t) + duB (t; u)

The early exercise interest earnings must also com-

pensate for loss of dividends on sale of stock.
Pricing American Calls on
a Tree
We consider a two period one year tree with a 5
dollar dividend at time 1 the half year point.

The tree is recombining before this time after this

time but splits at time 1:

We present the tree as follows.

ex-div
5 dollars
117.52 132.23
112.52
100 99.65

88.57 98.21
83.57
74.01

R(h) = 1:0304; D = :8857; U = 1:1752

 Call Values
The American Call Value Tree for a strike of K = 90
is
42:23
C1u
9:65
C0
8:21
C1d
0

We work back from the end where we know values,

but at each node we work out two values, exercise
and holding value. The value of the option is the
greated of the two and we note the decision related
to the value.
Time One Down State
Consider time one down state. We have a risk neu-
tral tree and we may use probabilities of :5:

The holding value is

1 1
8:21 = 3:9839
1:0304 2

The value of exercise is (88:57 90)+ = 0

So we have C1d = 3:9839 and we hold the option.

The value of m is
8:21 0
m =
98:21 74:01
= 0:3393
and

B = 3:9839 :3393 83:57

= 24:3714
 Time One Up State
The holding value is
1 1 1
42:23 + 9:65
1:0304 2 2
= 25:17

The exercise value is 117:52 90 = 27:52

Hence C1u = 27:52 and we exercise.

 Time 0
The holding value is
1 1 1
27:52 + 3:9839
1:0304 2 2
= 15:2872

The exercise value is 100 90 = 10

So C0 = 15:2872 and we hold the option with

27:52 3:9839
m =
117:52 88:57
= 0:8130

and

B = 15:2872 :8130 100

= 66:0128:
American Put on a Tree
Consider a put with strike 110 on our two period
tree.

The tree is
138:10
117:52
100 104:08
88:57
78:44
The put value tree is
0
P1u
P0 5:92
P1d
31:56
Time One Down State
The holding value is
1 1 1
5:92 + 31:56
1:0304 2 2
= 18:1871

The exercise value is (110 88:57) = 21:43

So P1d = 21:43 and we exercise.

 Time One Up State
The holding value is
1 1
5:92
1:0304 2
= 2:8727

The exercise value is 0

So P1u = 2:8727 and we hold with

5:92
m =
138:10 104:08
= :1740

and

B = 2:8727 + :1740 117:52

= 23:3212
 Time 0
The holding value is
1 1 1
2:8727 + 21:43
1:0304 2 2
= 11:7928

The exercise value is (110 100) = 10:

Hence P0 = 11:7928 and we hold with

2:8727 21:43
m =
117:52 88:57
= 0:6410

and

B = 11:7928 + :6410 100

= 75:8928:
American Option Values
on a Large Grid
We present a typical exercise region for an American
Put Option.

Value of American Put near exercise region equals

value of exercise, hence you do not need to know
the exercise region, as you exercise when the value
of put is at value of exercise.

We graph these values for our one year 90 put.

 Exercise B oundary For A meric an Put r=.06 s g=.2 T =1 K =90
92

90

88
Holding or Continuation Region

86
Exercise oc c urs on first pas s age into E xerc is e Region
Stock Price

84

82

80

Exercise Region

78

76
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
T ime

Figure 2: Exercise Region for one year 90 put with r=.06,

sg=.2.
 Value of American Put as a function of Spot

25

20

15
Option Price

Value at Maturity

10
Value at 9 months

Value at 6 months
Value at 3 months
5

0
80 85 90 95 100 105 110 115 120 125
Spot Price

Figure 3: American Put Option Values

 The American Put
Premium
The American Put Option Premium with no inter-
mediate dividends

P (S (t); t; K; T ) p(S (t); t; K; T )

is equal to the expected interest on the strike for the

time spent by the stock price in the exercise region.

Suppose we sell the American put for P and we buy the

European put for p: We ask what earnings or cash ‡ows
are accessed by this position.

Suppose the stock is outside the exercise region to begin

with. If it never enters the exercise region both puts
expire unexercised and they both have the same cash
‡ow of zero.
Next suppose the stock enters the exercise region at t <
T: We exercise the American put, short the stock and
receive the strike K: Now if the stock stays in the exercise
region till T we earn the interest on the strike for the time
T t and at T the European put we sold is exercised,
we pay out the strike, receive the stock and cancel the
short stock position. Our earnings are the interest on the
strike for the period T t:

Next suppose the stock has entered the exercise region

t; we have shorted the stock, received the strike and at
time u; t < u < T the stock leaves the exercise region.
We have earned the interest on the strike for the time
u t: At time u we spend the strike K to buy back
the stock for Su < K and we buy an American put for
K Su: The short stock position is cancelled, the strike
is spent and we are back to holding an American put with
the stock outside the exercise region. This is where we
started and the argument repeats.

The di¤erence P p is then the expected interest on the

strike for the time the stock spends in the exercise region.
If interest rates are low, the stock price is high relative to
the strike, then this premium will be small.