Option Investor Rationality Revisited: The Role of Exercise Boundary Violations

46 Pages Posted: 3 Jun 2017

See all articles by Robert H. Battalio

Robert H. Battalio

University of Notre Dame - Department of Finance

Stephen Figlewski

New York University - Stern School of Business

Robert Neal

Indiana University - Kelley School of Business

Date Written: May 30, 2017

Abstract

Do option investors rationally exercise their options? Numerous studies report evidence of irrational behavior. In this paper, we pay careful attention to intraday option quotes and reach the opposite conclusion. An exercise boundary violation (EBV) occurs when the best bid price for an American option is below the option’s intrinsic value. Far from being unusual, we show that EBVs occur very frequently. Under these conditions, the rational response of an investor liquidating an option is to exercise the option rather than sell it. Empirically, we find that the likelihood of early exercise is strongly influenced by the existence and duration of EBVs. Not only do these results reverse standard theory on American option valuation and optimal exercise strategy, but they also suggest that the ability to avoid selling at an EBV price creates an additional source of value for American options that is unrelated, and in addition to, dividend payments. This additional value may help explain why American options appear overpriced relative to European options.

Keywords: American Options, Option Exercise, Early Exercise Boundary, Investor Rationality

JEL Classification: G13, G12, G14

Suggested Citation

Battalio, Robert H. and Figlewski, Stephen and Neal, Robert, Option Investor Rationality Revisited: The Role of Exercise Boundary Violations (May 30, 2017). Available at SSRN: https://ssrn.com/abstract=2978812 or http://dx.doi.org/10.2139/ssrn.2978812

Robert H. Battalio

University of Notre Dame - Department of Finance ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States
574-631-9428 (Phone)
574-631-5255 (Fax)

Stephen Figlewski (Contact Author)

New York University - Stern School of Business ( email )

44 West 4th Street
Department of Finance Suite 9-160
New York, NY 10012-1126
United States
212-998-0712 (Phone)
212-995-4220 (Fax)

Robert Neal

Indiana University - Kelley School of Business ( email )

801 W. Michigan
Indianapolis, IN 46202
United States
317-274-3348 (Phone)
317-274-3312 (Fax)

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