Prices of American and European call according to Hull and Binomial model - Please help.

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Dear David & Fellow Members,

John Hull (in Chapter 9 and 10 - Options, futures and other derivatives) says that the price of an American and European call on a non dividend paying stock should be equal (since early exercise is not optimal). However, when we price using the binomial model, it takes into account the possibility of an early exercise, that is, in each node it takes the maximum of the intrinsic value (which will be the case if early exercise is allowed) and the option's PV in that node. This might sometime result in a higher price for the American Call.

I'd like to know what is wrong with my understanding here.

Regards,
Alan

 

[sl]

Hi Alan,

I believe the examples illustrated using Binomial two step are to price American Put option and not American Call option.

Thanks
Sundeep

 

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Thanks for the clarification Sundeep !

So, what you mean is we should price an American call on a non-dividend paying stock in the same way we price the European call, that is to say, we should not look at the intrinsic value.

Regards
Alan

 

[sl]

That's correct. You don't have to perform this step for the American call option on a non-dividend paying stock - max(intrinsic value, pv of option at that node)