The Implications of Early Exercise Policies for Option and Stock Returns

Abstract

In the first chapter of my thesis, I study the asset pricing implications of being able to optimally early exercise a plain-vanilla put option, contrasting the expected returns of equivalent American and European put options. Standard pricing models with stochastic volatility and asset-value jumps suggest that the expected return spread between them is positive, can be economically sizable, and widens with a higher optimal early exercise probability, as induced through a higher moneyness, shorter time-to-maturity, or lower underlying-asset volatility. Studying single-stock American put options and equivalent synthetic European options formed from applying put-call parity to American call options on zero-dividend stocks, my empirical work supports the theoretical predictions. My results, therefore, indicate that the early exercise feature can have a strong effect on option returns. In the second chapter, I introduce a dynamic trading strategy based on a theoretical proposition of Shreve (2004). Many studies report that American option investors often exercise their positions suboptimally late. Yet, when that can happen in case of puts, there is an arbitrage opportunity in perfect markets, mentioned in Shreve (2004), exploitable by longing the asset-and-riskfree-asset portfolio replicating the put and shorting the put. Using early exercise data, I show that the arbitrage strategy also earns a highly significant mean return with low risk in real single-stock put markets, in which exactly replicating options is impossible. In line with theory, the strategy performs particularly well on high strike-price puts in high interest-rate regimes. It further performs well on short time-to-maturity puts on low volatility stocks, consistent with evidence that investors do not correctly incorporate those characteristics into their exercise decisions. The strategy survives accounting for trading and short-selling costs, at least when executed on liquid assets. In the third chapter, I revisit the value-weighted stock return predictability of Black-Scholes (1973) option implied volatility spreads. Studies so far have explained this predictability using investors' informed trading activities in options ahead of the stock market and/or frictions in the underlying stock. Nevertheless, for single-stock American options, I show that the ability of implied volatility spreads to predict cross sectional stock returns is primarily driven by the friction-induced optimal early exercise of put options that is not accounted for in calculating implied volatility. The contribution of other factors to the predictive ability of implied volatility spreads are largely insignificant. Further evidence suggests that the predictability cannot be solely explained by the trading activities of informed option investors.

Date of Award	1 Aug 2021
Original language	English
Awarding Institution	The University of Manchester
Supervisor	Ian Garrett (Supervisor) & Kevin Aretz (Supervisor)