OPTIMAL EXERCISE OF AN EXECUTIVE STOCK OPTION BY AN INSIDER

Michael Monoyios and Andrew Ng
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Michael Monoyios: Mathematical Institute, University of Oxford, 24–29 St Giles', Oxford, OX1 3LB, United Kingdom
Andrew Ng: Mathematical Institute, University of Oxford, 24–29 St Giles', Oxford, OX1 3LB, United Kingdom

Chapter 21 in Finance at Fields, 2012, pp 475-498 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractWe consider an optimal stopping problem arising in connection with the exercise of an executive stock option by an agent with inside information. The agent is assumed to have noisy information on the terminal value of the stock, does not trade the stock or outside securities, and maximises the expected discounted payoff over all stopping times with regard to an enlarged filtration which includes the inside information. This leads to a stopping problem governed by a time-inhomogeneous diffusion and a call-type reward. We establish conditions under which the option value exhibits time decay, and derive the smooth fit condition for the solution to the free boundary problem governing the maximum expected reward, and derive the early exercise decomposition of the value function. The resulting integral equation for the unknown exercise boundary is solved numerically and this shows that the insider may exercise the option before maturity, in situations when an agent without the privileged information may not. Hence we show that early exercise may arise due to the agent having inside information on the future stock price.

Keywords: Mathematical Finance; Financial Mathematics; Risk Management; Asset Pricing; Computational Finance; Derivatives; Option Pricing; Portfolio Optimization (search for similar items in EconPapers)
Date: 2012
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