Economic Classroom Experiments/American Call Option

The owner of an American call option watches the stock price rise as the expiry date approaches and decides when to exercise or sell the option. Repeat play gives students an understanding of the fair market price for the option and shows that there is no benefit in exercising early.

Overview

Level

Any level

Prerequisite knowledge

None

Suitable modules

Any

Intended learning outcomes

1. Exercising early does worse than waiting; not worth paying a premium over and above a European call option that can only be exercised on its expiry date.
2. Discussion of how to calculate the fair market price for selling the option.

Computerized Version

There is a computerized version of this experiment available on the Exeter games site.

You may find the sample instructions helpful.

Abstract

Students play multiple rounds individually against the computer. The student is an investor in the stock market who has bought an American call option on a stock. The stock price starts at £2.00 and increases in 10 random increments of either 2.5% or 7.5%; the call option has a strike price of £2.50. The student watches as the increments are applied and can at any point decide to exercise the option or sell it on the open market. Any profits made in this way increase at a risk-free interest rate of 5% as each remaining increment is applied.

There are two versions of the game. In the first, the student is told the fair market price for selling the option as each increment is applied to the stock price. In the second, the student only learns what the price is after they have made the decision to sell but they are invited to guess beforehand what a fair price might be.