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When to exercise American calls and puts early

Question

On a stock that pays no dividends, can it ever be optimal to exercise an American call before expiry? What about an American put?

Short answer

Never for the call; sometimes for the put. The call is worth at least S−Ke−rτ>S−KS-Ke^{-r\tau}>S-K, so selling beats exercising, and exercise also gives up the insurance value. A deep in-the-money put can be worth exercising because receiving KK now earns interest, which can outweigh the small remaining optionality when SS is close to zero.

Adapted from Joshi, Denson & Downes, Quant Job Interview Questions and Answers, Q2.9, p.17; question and answer rewritten by SelfMadeQuant.com.

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