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.