Financial Frictions: Implications for Early Option Exercise and Realized Volatility

A call option on a stock is a common and widely used derivative. On an average trading day in 2015, more than 800,000 such options traded on the Chicago Board Options Exchange, the largest options exchange in the United States. Each option grants its owner the right to buy 100 of a specific stock at a pre-specified price, no later than a pre-specified date. For example, an option can grant the right to buy 100 General Electric shares for USD 31 each no later than October 21, 2016. An interesting issue is determining when an option is optimally exercised. Merton (1973) shows that in a world without frictions, a call option should never be exercised early, but only at expiration or just before the underlying stock pays a dividend. Chapter one of this thesis shows that suffciently severe frictions can make early exercise optimal. Short-sale costs especially represent an important driver of early exercise. Chapter two shows that when option owners exercise early, it predicts stock returns, consistent with option owners acting on private information. Chapter three does not include options but shows that demand shifts in the shorting market for stocks predict the volatility of the affected stocks, which is consistent with increases in differences of opinions among market participants.