0
$\begingroup$

At my university, there is a compulsory course in European option pricing (centered around Black Scholes formula).

But the course on optimal stopping theory (which is needed for American options) is an elective course.

If most real options are American, why so much focus on European option pricing in the literature and at universities?

For example, why is the Black Scholes formula so important? If it's for European options, and most options are American, then why do we care so much?

$\endgroup$
3
$\begingroup$

There is so much focus on european options because of it's more easy for learning purpose. One can't start teaching options that's are more complicated before explaining the basic style of options.
In most of mathematical finance books, they start by binomial tree for european options then they deal with black and scholes formula as a limit of binomial tree when time stamp tend to zero. Once this is done, they start showing the pricing of american options. it's more logical to do it this way!

| improve this answer | |
$\endgroup$
0
$\begingroup$

I agree completely with @Valometrics 's answer. European options are more easy to handle as they are not affected by the chance to be exercised before expiration. Moreover: the Black-Scholes-Merton model (1973) can be applied only to European options with underlying which pay and do not pay dividends, and to American call which do not pay dividends. Using the Cox, Ross, Rubinstein model (1978) one can price any type of options (even Bermudan). However, it is much easier to do it for European rather than for American options. Hence European options are used mainly to illustrate the fundamental concepts related to this derivative. In practice it is more likely you have to deal with American options. But you will be able to handle them only after mastering the workings of European ones. That is the rationale behind this praxis.

| improve this answer | |
$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.