Early Option Exercise: Never Say Never

Mads Vestergaard Jensen, Lasse Heje Pedersen

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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
JournalJournal of Financial Economics
Volume121
Issue number2
Pages (from-to)278-299
Number of pages22
ISSN0304-405X
DOIs
Publication statusPublished - Aug 2016

Keywords

  • Option exercise
  • Frictions
  • Short-sale costs
  • Transaction costs
  • Convertible bonds

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