Optimal exercise of American put options near maturity: A new economic perspective

Abstract

The critical price \(S^{*}\left( t\right) \) of an American put option is the underlying stock price level that triggers its immediate optimal exercise. We provide a new perspective on the determination of the critical price near the option maturity T when the jump-adjusted dividend yield of the underlying stock is either greater than or weakly smaller than the riskfree rate. Firstly, we prove that \(S^{*}\left( t\right) \) coincides with the critical price of the covered American put (a portfolio that is long in the put as well as in the stock). Secondly, we show that the stock price that represents the indifference point between exercising the covered put and waiting until T is the European-put critical price, at which the European put is worth its intrinsic value. Finally, we prove that the indifference point’s behavior at T equals \(S^{*}\left( t\right) \)’s behavior at T when the stock price is either a geometric Brownian motion or a jump-diffusion. Our results provide a thorough economic analysis of \(S^{*}\left( t\right) \) and rigorously show the correspondence of an American option problem to an easier European option problem at maturity .