Early Option Exercise: Never Say Never

Lasse Heje Pedersen, Mads Vestergaard Jensen

Research output: Working paperResearch

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.
Original languageEnglish
Place of PublicationLondon
PublisherCentre for Economic Policy Research
Number of pages64
Publication statusPublished - Dec 2015
SeriesCentre for Economic Policy Research. Discussion Papers
Number11019
ISSN0265-8003

Keywords

  • Convertible bonds
  • Derivatives pricing
  • Frictions
  • Option exercise
  • Short‐sale costs
  • Transaction costs

Cite this

Heje Pedersen, L., & Jensen, M. V. (2015). Early Option Exercise: Never Say Never. Centre for Economic Policy Research. Centre for Economic Policy Research. Discussion Papers, No. 11019 http://www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11019