Question

QUESTION 36

1. Suppose that there’s a high probability of bankruptcy for an underlying stock, which of the following statements is true?

	a.	The price of a European put option is lower compared to the price of an equivalent American put option.
	b.	The price of a European put option is higher compared to the price of an equivalent American put option.
	c.	Cannot determine based on the given information.

Answer 1

The correct answer is the first option i.e. a. The price of a European put option is lower compared to the price of an equivalent American put option.

An american Put Option in general is more valuable than a European Put option, keeping all other parameters constant. This is because you have the flexibility to exercise it early and not necessarily wait till expiration.

Further, in case there is a high probability of bankruptcy for an underlying stock, the stock is likely to see volatility in near future and it price may fluctuate a lot. In such a situation, the flexibility to exercise the option any time prior to expiry is a great thing to have. This flexibility will therefore make the American Put option more valuable than European Put option.

Hence, the first option is correct.