The Early Exercise Risk Premium

Abstract

We study the asset pricing implications of being able to optimally early exercise a plain-vanilla put option, contrasting the expected returns of American and equivalent European put options. Standard asset pricing models - including models with stochastic volatility and jumps - suggest that the spread in the expected return between the American and European options is positive and widens with a higher early exercise probability, as induced through a higher moneyness, shorter time-to-maturity, or lower underlying-asset volatility. Studying single-stock American put options and equivalent synthetic European options, which we form from applying put-call parity to American call options written on zero-dividend stocks, our empirical work strongly supports our theoretical predictions.

Keywords: Empirical asset pricing, cross-sectional option pricing, put options, early exercise

JEL Classification: G11, G12, G15