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FRM Part I · FRM Exam Part I · Binomial Trees

Consider an American put on a non-dividend-paying stock. Holding the other inputs constant, which change makes early exercise of the put more attractive?

A higher risk-free interest rate makes early exercise of an American put more attractive, because exercising lets the holder receive the strike immediately and earn interest on it. Higher volatility and longer maturity raise time value, and a higher stock price makes the put less in the money, so these favour holding.

  1. AA higher volatility of the stock
  2. BA higher risk-free interest rateCorrect
  3. CA longer time to expiry
  4. DA higher current stock price

Explanation

Early exercise of a put lets the holder receive the strike now and earn interest on it, so a higher risk-free rate raises the benefit of exercising early. Higher volatility and longer time to expiry increase the option's time value, which favours holding. A higher stock price moves the put away from the money and reduces the case for exercise.

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