In the first chapter of my thesis, I study the asset pricing implications of being able to optimally early exercise a plainvanilla put option, contrasting the expected returns of equivalent American and European put options. Standard pricing models with stochastic volatility and assetvalue 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 timetomaturity, or lower underlyingasset volatility. Studying singlestock American put options and equivalent synthetic European options formed from applying putcall parity to American call options on zerodividend 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 assetandriskfreeasset 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 singlestock put markets, in which exactly replicating options is impossible. In line with theory, the strategy performs particularly well on high strikeprice puts in high interestrate regimes. It further performs well on short timetomaturity 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 shortselling costs, at least when executed on liquid assets. In the third chapter, I revisit the valueweighted stock return predictability of BlackScholes (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 singlestock American options, I show that the ability of implied volatility spreads to predict cross sectional stock returns is primarily driven by the frictioninduced 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) 

The Implications of Early Exercise Policies for Option and Stock Returns
Gazi, A. (Author). 1 Aug 2021
Student thesis: Phd