Microsoft PowerPoint - PoF.ppt

American optionsƒ 220

The procedure for valuing an American option is as follows:

ƒ

At every node also calculate th

e intrinsic value of the American

option, IV(.).Recall: Intrinsic value of an opti

on = profit / loss if exercised

immediately.

ƒ

If

IV(.) > V(.)

Ä

Early exercise, i.e. we re

alize the intrinsic value.

Ä

Since everybody agrees with the fact that the

IV(.) > V(.)

nobody

will be willing to sell the option

for less than its immediate exercise

value therefore we continue our calculation with

IV(.)

instead of

V(.).

ƒ

If

IV(.) < V(.)

Ä

Early exercise is not desirable.

Ä

We continue our

calculation without changes!

Derivative securities: Options - Binomial asset pricing model