Why an American Call = European Call

(non 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. Jensens Inequality
From Wikipedia, we have that a function f(x) is convex if:
x
1
, x
2
X, [0, 1] : f((1 ) x
1
+ x
2
) (1 ) f(x
1
) + f(x
2
) (1)
for = 0,3, x
1
= 2, x
2
= 3 and f(x) = x
2
; you can prove that the previous inequality remains.
When we plot the pay-o of a European Call option at maturity, we found that the function
Pay-o at maturity is convex. Then, we can dene:
e
r(Tt)
= (2)
x
1
= 0 (3)
g(S
(T)
) = (S
(T)
K)
+
= (S
(T)
K) I
(S
(T)
K)
1
(4)
Replacing equation 2, 3 and 4 in equation 1, and taking expectations
2
, we found
1
Option pay-o at maturity of a Call.
2
Risk neutral world.
1
E[g(e
r(Tt)
S
(T)
)|F
(t)
]

Here use Jensens Inequality
E[e
r(Tt)
g(S
(T)
)|F
(t)
] (5)
Now, lets remember what does Jensens Inequality state (Wikipedia)
Jensens Inequality
If S
(T)
is random and g(S
(T)
) is convex (option pay-o), then:
g(E[S
(T)
]) E[g(S
(T)
)] (6)
replacing 6 in 5
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)
)
(7)
I hope that you dont get lost with the implementation of the previous equation. In step number
4 of the previous equation we have the expectation of the exponential Martingala which is equal
to 1 (ask if any doubt). Replacing equation 7 in 5
g(S
(t)
) E[e
r(Tt)
g(S
(T)
)|F
(t)
] t [0, T] (8)
operating (taking what is known till t);
e
rt
g(S
(t)
)

American option Pay-o
E[e
r(T)
g(S
(T)
)|F
(t)
]

European Option Pay-o
t [0, T] (9)
This means that the European Option Pay-o dominate the American Option Pay-o.
2