Question

QUESTION 3 Give an intuitive explanation of why the early exercise of an American put becomes more attractive as the risk-free rate increases and volatility decreases.

Answer 1

Answer: American Put option- Put option is the right to sell. It is Put option that can be exercised anytime on or before expiry.

Early exercise of an American put option becomes more attractive because of higher interest earned than the insurance element lost. Increasing risk free rate increases the fixed value rate that makes the early exercise of American put option more attractive, on the other hand, when volatility decreases, insurance element becomes less valuable.