- CFA Exams
- June 2016 Level II > Study Session 17. Derivative Investments: Options, Swaps, and Interest Rate and Credit Derivatives > Reading 49. Option Markets and Contracts
- 12. Early exercise of American options on forwards and futures contracts
Subject 12. Early exercise of American options on forwards and futures contracts
American options can be exercised early. In general:
- For calls, early exercise can be worthwhile if the underlying makes cash payments during the life of the option.
- For puts, there is nearly always a possibility of early exercise.
For American options on futures:
- For calls, early exercise may be worthwhile even if the underlying does not make any cash payments. For example, if the holder of a deep-in-the-money American call option exercises it and establishes a futures position, he earns interest on the futures margin account.
- For puts, early exercise may also be worthwhile. For example, a similar argument holds for deep-in-the-money American put options on futures.
Note that a forward contract does not pay off until expiration, in contrast to the mark-to-market procedure of futures contracts. Therefore, it's not worthwhile to exercise an American call or put on a forward contract as doing so would only establish a long or short position in a forward contract and would not pay any cash until expiration.
Practice Question 1An American call on a forward contract should carry ______ a European call on a forward contract, and an American call on a futures contract should carry ______ a European call on a futures contract.
A. a higher price than, a higher price than.
B. the same price as, a higher price than.
C. the same price as, the same price as.Correct Answer: B
If it's worthwhile to exercise an American option earlier, it should carry a higher price than its European counterpart.
Practice Question 2The effect of dividends on a stock on early exercise of an American call is to:
A. make early exercise less likely.
B. have no effect on early exercise.
C. make early exercise more likely.Correct Answer: C
Cash flows from the underlying are the only reason for early exercise of a call.
Practice Question 3Which factors DISCOURAGE early exercise of American puts?
I. Dividends if the underlying is a stock.
II. Storage costs if the underlying is a commodity.
III. Coupon interests if the underlying is a bond.Correct Answer: I and III
Practice Question 4Which factor could cause an early exercise of American calls?
A. Cash payments on the underlying.
B. Changes in risk-free interest rates.
C. Changes in volatility of the underlying.Correct Answer: A
Cash payments on the underlying are the only reason to exercise American calls early.
Practice Question 5Which factors ENCOURAGE early exercise of American puts?
B. underlying volatility.
C. carrying costs on the underlying.Correct Answer: C
Carrying costs discourage exercise for American calls and encourage exercise for American puts.
Study notes from a previous year's CFA exam:
j. compare American and European options on forwards and futures, and identify the appropriate pricing model for European options.