The Early Exercise Risk Premium

Management Science, Forthcoming

87 Pages Posted: 16 Oct 2019 Last revised: 10 Nov 2023

See all articles by Kevin Aretz

Kevin Aretz

Alliance Manchester Business School

Adnan Gazi

University of Liverpool - Management School (ULMS)

Date Written: October 15, 2023

Abstract

We study the asset pricing implications of being able to optimally early exercise plain-vanilla puts, contrasting expected raw and delta-hedged returns across equivalent American and European puts. Our theory suggests that American puts yield less negative raw but more negative delta-hedged expected returns than equivalent European puts. The raw (delta-hedged) spread widens with a higher early exercise probability, as induced through, for example, moneyness, time-to-maturity, and underlying-asset volatility (variance and jump risk premiums). An empirical comparison of single-stock American puts with equivalent synthetic European puts formed from put-call parity supports our theory if and only if we allow for optimal early exercises in our return calculations. More strikingly, allowing for optimal early exercises significantly alters the profitability of 14 out of 15 well-known option anomalies, with the average absolute change equal to 32% and five anomalies becoming insignificant.

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

JEL Classification: G11, G12, G13

Suggested Citation

Aretz, Kevin and Gazi, Adnan, The Early Exercise Risk Premium (October 15, 2023). Management Science, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3465453 or http://dx.doi.org/10.2139/ssrn.3465453

Kevin Aretz

Alliance Manchester Business School ( email )

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HOME PAGE: http://www.kevin-aretz.com

Adnan Gazi (Contact Author)

University of Liverpool - Management School (ULMS) ( email )

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