IAI Actuarial Core Principles · Economic Modelling · Binomial option-pricing model
Which feature of a deep in-the-money American put on a non-dividend-paying share makes early exercise potentially optimal?
Early exercise of a deep in-the-money American put can be optimal because the strike received now earns interest, and this gain can exceed the small remaining time value of holding the option.
- AThe interest earned on the strike received now outweighs the remaining time value of the optionCorrect
- BThe share price volatility is zero
- CThe put has a higher delta than a call
- DThe risk-free rate is negative
- The share price cannot fall further
Explanation
Exercising a put gives the strike in cash immediately, which can earn interest at the risk-free rate. When the put is deep in the money, the remaining time value is small and may be less than that interest gain, so exercise is optimal. Negative rates would remove this incentive.
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