Question

Describe in detail the two kinds of options contracts that exist, also describe the advantages and disadvantages of each? making sure to include an example of each with an explanation of price differentials.

Answer 1

Ans : Two kind of option contract :

1) American option

2) European options

American options are options giving right but not obligation to the buyer to execute the contract at any time before maturity on the underlying conditions like strike price.

Adv: It is executed at tany point of time, for example American call option, if price in the market goes above the strike price at any point upto the maturity , can be executed immediately.

Disadv: It is at higher premium, so costly.

European option :  are options giving right but not obligation to the buyer to execute the contract at maturity on the underlying conditions like strike price.

Adv : It is comparitively cheaper to American option, so inital cost is less.

Disadv: It can only be executed on date of maturity on the strike price and cannot give advantage to execute before the maturity when price seems to be better.

For example Let's consider a stock having current value = 10, 35% probability that after each month the price go up by 10% and 65% to go down by 10%. American call option of 2 months strike price 10.8 , interest rate = 12%

In this case the option can be executed at t =1 month as price will be more than the strike price or can be executed at t=2 , where price is 12.1, price = 0.16

In case if it is european option , the option can be executed only at t= 2 , hence price will be derived accordingly.

Price = 0.14