Early Option Exercise: Never Say Never

62 Pages Posted: 27 Sep 2015 Last revised: 18 Mar 2016

See all articles by Mads Vestergaard Jensen

Mads Vestergaard Jensen

Copenhagen Business School

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Date Written: September 25, 2015

Abstract

A classic result by Merton (1973) is that, except just before expiration or dividend payments, one should never exercise a call option and never convert a convertible bond. We show theoretically that this result is overturned when investors face frictions. Early option exercise can be optimal when it reduces short-sale costs, transaction costs, or funding costs. We provide consistent empirical evidence, documenting billions of dollars of early exercise for options and convertible bonds using unique data on actual exercise decisions and frictions. Our model can explain as much as 98% of early exercises by market makers and 67% by customers.

Keywords: option exercise, frictions, short-sale costs, transaction costs, convertible bonds, derivatives pricing

JEL Classification: G11, G12, G13, G14

Suggested Citation

Jensen, Mads Vestergaard and Pedersen, Lasse Heje, Early Option Exercise: Never Say Never (September 25, 2015). Available at SSRN: https://ssrn.com/abstract=2665629 or http://dx.doi.org/10.2139/ssrn.2665629

Mads Vestergaard Jensen (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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