CFA Level II ExamDerivativesMedium
An American call option on a non-dividend-paying stock has a current price of $5. The stock price is $50, the strike price is $45, and the time to expiration is 6 months. The risk-free rate is 4% compounded continuously. Which of the following statements about the early exercise of this American call option is most accurate?
- AEarly exercise is optimal if the interest rate is very high.
- BEarly exercise is always optimal when the option is deep in-the-money.
- CEarly exercise is never optimal for an American call on a non-dividend-paying stock.
- DEarly exercise is only optimal if the option is near expiration.
Show answer & explanationAnswer & explanation
Correct answer: C. Early exercise is never optimal for an American call on a non-dividend-paying stock.
For an American call option on a non-dividend-paying stock, early exercise is never optimal. This is because exercising early means giving up the time value of the option and the opportunity to earn interest on the strike price until expiration. The option holder would be better off selling the option in the market than exercising it early.
Why the other options are wrong
- A. Incorrect. A high interest rate makes holding the option more attractive (as the PV of the strike is lower), not less, thus not favoring early exercise.
- B. Incorrect. While deep in-the-money, early exercise still means forfeiting time value and the interest on the strike price.
- D. Incorrect. Early exercise is generally not optimal for non-dividend-paying calls, regardless of proximity to expiration, for the reasons stated.
Early Exercise (American Call, Non-Dividend)
The decision to exercise an American call option prior to its expiration date for an underlying asset that does not pay dividends.
- Never optimal for American calls on non-dividend-paying stocks.
- Exercising early forfeits the option's time value.
- Exercising early means paying the strike price sooner, giving up interest on that capital.
Memory trick: No Dividends, No Early Call.