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Solutions and Proofs: American Options

An Undergraduate Introduction to Financial Mathematics

J. Robert Buchanan

J. Robert Buchanan

Solutions and Proofs: American Options

Parity I
Proof: Assume to the contrary that C a + K < S + P a . Sell the security, sell the put, and buy the call. This produces a cash ow of S + P a C a . Invest this amount at the risk-free rate, If the owner of the American put chooses to exercise it at time 0 t T , the call option can be exercised to purchase the security for K . The net balance of the investment is (S + P a C a )ert K > Kert K 0. If the American put expires out of the money, exercise the call to close the short position in the security at time T . The net balance of the investment is (S + P a C a )erT K > KerT K > 0.
J. Robert Buchanan Solutions and Proofs: American Options

Parity II

Thus the investor receives a non-negative prot in either case, violating the principle of no arbitrage.

J. Robert Buchanan

Solutions and Proofs: American Options

Another Inequality I
Proof: Suppose S + P a < C a + KerT . Sell an American call and buy the security and the American put. Thus C a S P a is borrowed at t = 0. If the owner of the call decides to exercise it at any time 0 t T , sell the security for the strike price K by exercising the put. The amount of loan to be repaid is (C a S P a )ert and (C a S P a )ert + K = (C a + Kert S P a )ert (C a + KerT S P a )ert since r > 0. By assumption S + Pa < Ca + KerT , so the last expression above is positive.

J. Robert Buchanan

Solutions and Proofs: American Options

A Surprising Equality I
Proof: Suppose that C a > C e . Sell the American call and buy a European call with the same strike price K , expiry date T , and underlying security. The net cash ow C a C e > 0 would be invested at the risk-free rate r . If the owner of the American call chooses to exercise the option at some time t T , sell short a share of the security for amount K and add the proceeds to the amount invested at the risk-free rate. At time T close out the short position in the security by exercising the European option. The amount due is (C a C e )erT + K (er (T t ) 1) > 0.

J. Robert Buchanan

Solutions and Proofs: American Options

A Surprising Equality II

If the American option is not exercised, the European option can be allowed to expire and the amount due is (C a C e )erT > 0.

J. Robert Buchanan

Solutions and Proofs: American Options

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