American options

Definition

American options are financial derivatives that give the holder the right to buy or sell an underlying asset at a specified price before or on the expiration date. They offer more flexibility than European options, which can only be exercised at expiration.

5 Must Know Facts For Your Next Test

1. American options can be exercised at any time up to the expiration date, providing greater flexibility in risk management.
2. The premium for American options is typically higher than that of European options due to their flexibility.
3. They are commonly used in equity and commodity markets for hedging and speculative purposes.
4. Valuation models like the Binomial model are often used to price American options due to their early exercise feature.
5. American options play a crucial role in managing exchange rate risks, especially for multinational corporations dealing with currency fluctuations.

Review Questions

• What is the primary difference between American and European options?
• Why might an investor prefer an American option over a European option?
• How does the ability to exercise an American option before expiration impact its pricing?

Related terms

European Options: Options that can only be exercised at the end of their life, on their expiration date.

Option Premium: The price paid by the buyer to the seller to acquire an option contract.

Binomial Model: A mathematical model used to price options by considering possible future outcomes and their probabilities.