of a “European-style” option has the right to exercise the option only on the expiration date,
while the writer of this option may be assigned only on the expiration date of the option. On
the other hand, the holder of an “American style” option has the right to exercise the option
on any day until expiry, while the writer of an American style option may be assigned on any
day until expiry.
European style option – an option where the purchaser has the right to exercise only
at expiration.
American style option – an option a purchaser may exercise for early value at any
time over the life of the option up to and including its expiration date.
For example, if an option expires on 28th March, with an American style option, the holder
could exercise the option on 5th March and expect delivery of the currencies involved to
take effect two business days later. With a European style option, exercise can only occur on
28th March, with delivery then two business days later. It must be remembered that there is
a difference in price between the two styles of option, but only sometimes. The difference
in price occurs because there is a difference in the interest rates each currency attracts. With
American options, the intrinsic value is priced against the spot or the forward outright price,
whichever is the most advantageous. This is because the American option can be exercised for
spot value at any time during the life of the option.
If the call currency (right to buy) of the option has a higher interest rate than the put currency
(right to sell), there will be an advantage in calculating the intrinsic value against spot rather
than against the forward outright rate. Therefore, the risk that the writer of the American
option has is that at some point in time, if the option is so far in-the-money that there is
negligible time value remaining, the holder may exercise early. This would mean the writer
would incur the differential interest cost of borrowing the higher interest rate currency and
lending the lower interest rate currency. If this happens, the option is said to be at logical
exercise.
As the American style option is more flexible, shouldn’t it be more expensive all the time?
Actually, the American option is not really more flexible than the European option. True, it
can be exercised early and therefore the intrinsic value can be realised immediately but unless
the option is at logical exercise, the holder would be better to sell the option back and receive
the premium. Remember, the premium represents the intrinsic value of an option plus time
value. This is true for both American and European options and in both cases, if the option is
not at logical exercise, and the aim is to realise maximum profit, it would be better to sell than
to exercise the option.
Examples of cases when it would be better to pay the extra premium and buy a more
expensive American style option are:
- In buying an option where the call currency has the higher interest rate and it is expected that the interest rate differential will widen significantly;
- In buying an option where the interest rates are close to each other and it is expected that the call interest rate will move above the put interest rate;
- In buying an out-of-the-money option with interest rates as in both above and it is expected that the option will move significantly into the money, then the American style option is more highly leveraged and will produce higher profits.
Read More: AMERICAN AND EUROPEAN STYLE OPTIONS
