Early Exercise of American Put Options: Investor Rationality on the Swedish Equity Options Market
Journal of Futures Market , Vol. 20, pp. 167-188, 2000
Posted: 22 Nov 2003
We investigate how well the actual exercise behaviour of American put options corresponds to the early exercise rules using Swedish equity option data. The numerical binomial model according to Cox et al. (1979) is used to compute a critical exercise price, above which a put option should be exercised early, in order to establish the theoretically optimal early exercise behaviour. We find several examples of irrational early exercise behaviour, both faulty actual exercises and failures to exercise. Most of the decisions to exercise the put options conform to rational exercise behaviour, whereas a large number of failures to exercise are found. This suggests that traders do not monitor their put option positions with sufficient care. By carrying out a sensitivity analysis, we conclude that the results persist after taking into account transaction costs associated with option exercise and the possibility that the volatility is not correctly estimated. A direct model-independent test of the failures to exercise, where the exercise value of the option is compared to its market bid price, shows that the results cannot be explained by the choice of model. Most of the found failures are regarded as failures also according to the direct test. Finally, we compute the average loss due to incorrect exercise behaviour in order to assess the economic significance of the results. Although occurring frequently, the failures to exercise do not appear to be costly.
Note: This is a description of the paper and not the actual abstract.
Keywords: American put options, Early exercise, Investor rationality
JEL Classification: G10, G13
Suggested Citation: Suggested Citation