Question

Question 4

(a) Discuss the difference between American and European options. Should they be priced the same? Why or why not?

(b) What are the benefits and risks of an OTC market relative to an exchange? How does the exchange manage the risks associated with OTC?

(c) Suppose Reserve Bank of Australia decides to reduce the cash rate to 0. What do you think will be the effect on AUD? Use UIP to explain the effect

Answer 1

Ans:

American Options:

In case of American type options - you can exercise the option any time before expiration if you want to.

For example: If you own a call option and there is only 10 days of expiration, you can still exercise that option and buy stock at strike price.

Now, what we're talking about here is actually physically exercising tyour option and converting that one option into 100 shares of underlying stock. This is different than if you wanted to actually just get rid of your position and sell it back to the market. you could still make a proit that way. But if you want to exercise the option, you want to actually ownthe underlying shares of stock, then this is what you would do with an American style option. Again, you can do this any time beore expiration and up to expiration.

European Options:

You can ONLY exercise European style options at expiration. Index and forex options (RUT, SPX, NDX,USD/EUR, etc.) are typically european style options which means they are typically cash settled and they're settled only on expiration. Youcan't actually physically go in and buy shares of the SPX because it's just and index.

In our last example, if there was 10 days to go and you wanted to exercise your option and buy the actual stock, you couldn't do that. You would have to wait until the actual expiration date. Now, this doesn't mean you can't get out of the contract. This just means you can't convert it to underlying shares. You can easily sell this contract back to market and get whatever value is left in it and still create a profit.

These are less common and most of the options you're going on trade are going to be American style, meaning you can exercise them or convert them any time in the future.

As always with this ability, you have more value since the owner of an American option has the right to exercise at any time before it expires, they have more Flexbility which gives the option contract more value all other things being equal.