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Market microstructure effects on the direct measurement of the early exercise premium in exchange-listed options

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  • Michael Dueker
  • Thomas W. Miller, Jr.

Abstract

The Chicago Board Options Exchange concurrently listed European-style and American-style options on the Standard and Poor?s 500 Index from April 2, 1986 through June 20, 1986. We match near-the-money American option quotes with the most nearly contemporaneous, otherwise identical, European option quote. In this unique sample, the bid-ask spread for the American options is twice as large as the bid-ask spread for the European options. We find that the differences in the size of the bid-ask spreads and non-contemporaneous observations create an errors-in-variables problem that, if ignored, contaminates direct measures of the early exercise premium for American options. Our findings call into question other empirical measures of the early exercise premium that do not take into account these microstructure effects. We illustrate our errors-in-variable interpretation with a simulation of regressing American trades on European trades.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 1996-013.

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Date of creation: 1996
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Handle: RePEc:fip:fedlwp:1996-013

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Related research

Keywords: Liquidity (Economics) ; Options (Finance) ; Stock market;

References

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  1. Phillips, Susan M. & Smith, Clifford Jr., 1980. "Trading costs for listed options : The implications for market efficiency," Journal of Financial Economics, Elsevier, Elsevier, vol. 8(2), pages 179-201, June.
  2. Dan W. French & Edwin D. Maberly, 1992. "Early Exercise Of American Index Options," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 15(2), pages 127-137, 06.
  3. Kamara, Avraham & Miller, Thomas W., 1995. "Daily and Intradaily Tests of European Put-Call Parity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(04), pages 519-539, December.
  4. Figlewski, Stephen, 1984. " Hedging Performance and Basis Risk in Stock Index Futures," Journal of Finance, American Finance Association, American Finance Association, vol. 39(3), pages 657-69, July.
  5. Harvey, Campbell R & Whaley, Robert E, 1991. " S&P 100 Index Option Volatility," Journal of Finance, American Finance Association, American Finance Association, vol. 46(4), pages 1251-61, September.
  6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  7. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. " Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, American Finance Association, vol. 42(2), pages 301-20, June.
  8. MacBeth, James D & Merville, Larry J, 1979. "An Empirical Examination of the Black-Scholes Call Option Pricing Model," Journal of Finance, American Finance Association, American Finance Association, vol. 34(5), pages 1173-86, December.
  9. Sung, Hyun Mo, 1995. " The Early Exercise Premia of American Put Options on Stocks," Review of Quantitative Finance and Accounting, Springer, Springer, vol. 5(4), pages 365-73, December.
  10. Whaley, Robert E., 1982. "Valuation of American call options on dividend-paying stocks : Empirical tests," Journal of Financial Economics, Elsevier, Elsevier, vol. 10(1), pages 29-58, March.
  11. Vijh, Anand M, 1990. " Liquidity of the CBOE Equity Options," Journal of Finance, American Finance Association, American Finance Association, vol. 45(4), pages 1157-79, September.
  12. Blomeyer, Edward C. & Johnson, Herb, 1988. "An Empirical Examination of the Pricing of American Put Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(01), pages 13-22, March.
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