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Journal of Financial Economics Vol. 121 No. 2 2016

Early option exercise: Never say never

Mads Vestergaard Jensen1; Lasse Heje Pedersen2,3,1,4

1 Copenhagen Business School · 2 Capital University · 3 New York University · 4 Centre for Economic Policy Research

open access

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.

DOI
10.1016/j.jfineco.2016.05.008
Volume
121
Issue
2
Pages
278-299
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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