The Suboptimality of Early Exercise of Futures-Style Options: A Model-Free Result, Robust to Market Imperfections and Performance Bond Requirements

Abstract:     
Options on futures traded in Eurex, Euronext-LIFFE and SFE are subject to futures-style premium posting (FSPP): the premium is not paid up front but marked to market. In the U.S., steps to adopt FSPP have been taken. The previous literature has shown that early exercise of such options is neither optimal for Black's dynamics of the underlying futures price, nor in an equilibrium CIR setting. The paper proves that these options, either calls or puts, are never optimally exercised early under any possible dynamics of the underlying and interest rates. It also proves that, unlike the case of plain-vanilla calls on non-dividend-paying stock, the previous result is robust to transaction costs, illiquidity and collateral requirements. Hence, assuming that investors are rational, it is superfluous to keep the American feature among the specifications of futures-style options.

Number of Pages in PDF File: 36

Keywords: Futures-style, early, early exercise, options, futures, options on futures, transaction costs, performance, performance bond, SPAN, put-call, parity, put-call parity, LIFFE, EUREX, SFE

JEL Classification: G13, G23

working papers series