An Explanation of Seemingly Anomalous Time Premium Behavior for American Put Options

Robert Geske and Kuldeep Shastri

University of California at Los Angeles, Anderson Graduate School of Management from Anderson Graduate School of Management, UCLA

Abstract: ABSTRACT It is thought that American options always gain value as the time to the option's expiration date increases. Merton (1973) proved this result using simple arbitrage arguments for options on non-dividend paying stocks. However, market prices reveal that (i) an American put can increase in value as calendar time passes diminishing the options time to expiration and (ii) two puts which differ only in expiration cycle can "sell" for the same price (i.e. a zero differential time premium). This paper demonstrates that dividend payments can cause this seemingly anomalous time premium behavior for American put options.

Date: 1986-11-01
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