Why an American Call = European Call

(dividend payment)
Mauricio Bedoya
javierma36@gmail.com
August 2014
To understand the title of this blog, you must know:
1. What is a convex function ?
2. Jensen Inequality
An American Call option diers from the European counterpart due to the dividend payment.
To understand this, its necessary to remember that both American and European dividend
Call options, are function of S
(t)
. If S
(t)
increase, both options should increase. We can say that:
American Option European Option t [0,T]
Just think that more time to exercise the option should translate in at least, in more value.
The price process of a stock that pays continuous dividend is:
S
(t)
= S
(0)
e
(rfq0,5)t+dw(t)
(1)
with rf (risk free rate), q (dividend rate), (volatility) constant, and dw (N[0,

t]). A little
algebra, show that
S
(t)
= S
(0)
e
qt

Starting point
e
(rf0,5)t+dw(t)
The previous equation show that as q increase, S
(t)
decrease (nd the derivative). At the sa-
me time, as t increase, the starting point of the process decrease (nd the discount expectation).
The inconvenient with equation 1, is that continuous dividend payment is not observable. Now,
imagine that time [0,T] correspond to the day prior the ex-dividend date. The American
call option allow to choose between exercising before the ex-dividend date (to get the right to
receive the dividend) or in a latter date. Mathematically we have:
1
g
(S

)
= Max(S
()
K; C
[,T]
)
were S
()
K is the option payment at ; and C
[,T]
is the option value with a remaining
maturity equal to T and initial value S
()
(1 q).
g

groups two convex functions and the maximum of two convex function is still convex. With
this in mind, we can use the properties of a convex function and conclude that:
E[g(e
r(t)
S
()
)|F
(t)
]

Use Jensen Inequality here
E[e
r(t)
g(S
()
)|F
(t)
] (2)
In the previous equation Im considering only the continuous time until , and ignoring the
remaining time (between T and ). Why?; If you dont exercise at , you can found in the
blog: Why an American Call = European Call (non dividend payment); that in the absent of
dividend payments, European Option will dominate American Option.
Now, using Jensen Inequality and operating in equation 2, we found that
E[g(e
r(Tt)
S
(T)
)|F
(t)
] g(E[e
r(Tt)
S
(T)
)|F
(t)
])
g(e
rt
E[e
rT
S
(T)
|F
(t)
])
g(e
rt
E[e
rT
S
(t)
e
(r0,5
2
)(Tt)+(w(T)w(t))
|F
(t)
])
g(e
rt
S
(t)
e
rt
E[e
0,5
2
(Tt)+(w(T)w(t))
|F
(t)
])
g(S
(t)
)
(3)
re-writing equation 1, we get
g(S
(t)
) E[e
r(t)
g(S
()
)|F
(t)
] (4)
This means that its optimal only to exercise the call option at any time before .
2