Early Option Exercise: Never Say Never

Lasse Pedersen and Mads Vestergaard Jensen

No 11019, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Convertible bonds; Derivatives pricing; frictions; Option exercise; Short-sale costs; Transaction costs (search for similar items in EconPapers)
JEL-codes: G11 G12 G13 G14 (search for similar items in EconPapers)
Date: 2015-12
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Journal Article: Early option exercise: Never say never (2016)
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