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Early Option Exercise: Never Say Never

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  • Pedersen, Lasse Heje
  • Vestergaard Jensen, Mads

Abstract

A classic result by Merton (1973) is that, except just before expiration or dividend payments, one should never exercise a call option and never convert a convertible bond. We show theoretically that this result is overturned when investors face frictions. Early option exercise can be optimal when it reduces short-sale costs, transaction costs, or funding costs. We provide consistent empirical evidence, documenting billions of dollars of early exercise for options and convertible bonds using unique data on actual exercise decisions and frictions. Our model can explain as much as 98% of early exercises by market makers and 67% by customers.

Suggested Citation

  • Pedersen, Lasse Heje & Vestergaard Jensen, Mads, 2015. "Early Option Exercise: Never Say Never," CEPR Discussion Papers 11019, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:11019
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    Cited by:

    1. repec:eee:dyncon:v:80:y:2017:i:c:p:75-100 is not listed on IDEAS
    2. Antonio Cosma & Stefano Galluccio & Paola Pederzoli & Olivier Scaillet, 2016. "Early exercise decision in American options with dividends, stochastic volatility and jumps," Papers 1612.03031, arXiv.org.
    3. repec:spr:binfse:v:59:y:2017:i:6:d:10.1007_s12599-017-0507-z is not listed on IDEAS

    More about this item

    Keywords

    convertible bonds; derivatives pricing; frictions; option exercise; short-sale costs; transaction costs;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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