- CFA Exams
- 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
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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 1
An 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 2
The 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 3
Which 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 4
Which 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 5
Which factors ENCOURAGE early exercise of American puts?A. dividends.
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:
12. Early exercise of American options on forwards and futures contracts