Question

In the Binomial Option Pricing Model, compare the price of an American Put and a European put price using the same 5 step tree with 3 months to maturity and a sigma of 23%. Let the starting futures price be 72, the strike be 75 and let r = 5%.

Answer 1

American Put and a European put price

Using the same 5 step tree with 3 months to maturity and a sigma of 23%. Let the starting futures price be 72, the strike be 75 and let r = 5%.

American Put:

European Put:

The difference in the values at each node in the binomial tree can be identified from the above figures. The values at each node differ mainly because of the time of expiration of the two different types of option.

An American option can be exercised at any time before the expiry whereas the European option can only be exercised at the expiry time. This has been the main difference in comparing the values at each node.