Final answer:
American options can be exercised early, but there are several factors such as time value, opportunity cost, dividends, and interest rates that influence whether an option holder chooses to wait. These economic considerations often outweigh the benefits of early exercise, resulting in the option being held until closer to expiration.
Step-by-step explanation:
Among European and American options, it is the American options that can be exercised early. While this provides greater flexibility compared to European options, which can only be exercised at expiration, the phenomenon of early exercise is not common due to several factors. The decision to hold an option rather than exercising it early is often influenced by the time value that is still inherent in the option's price. In addition to time value, opportunity cost, interest rates, and dividends are also key factors that discourage the early exercise of American options.
Options carry not only intrinsic value but also time value, which represents the potential for additional gains due to market fluctuations. Exercising an option early eliminates the possibility of realizing any future time value, which might not be advantageous unless the option is deep in the money and the time value is minimal. Furthermore, the opportunity cost of forgoing the interest that could be earned on the proceeds from an early exercise also plays a role. Similarly, if a dividend is expected, holders might postpone the exercise to capture dividend payments, especially if the dividend outweighs the time value lost by holding the option. Lastly, interest rates may affect the decision; higher rates could encourage earlier exercise to reinvest the proceeds at a higher rate.