Journal of Multinational Financial Management 10 (2000) 461 479 www.elsevier.

com/locate/econbase

The early exercise premium in American put option prices

Malin Engstro m, Lars Norde n *
Department of Corporate Finance, School of Business, Stockholm Uni6ersity, S -106 91 Stockholm, Sweden Received 15 July 1999; accepted 18 February 2000

Abstract This study estimates the value of the early exercise premium in American put option prices using Swedish equity options data. The value of the premium is found as the deviation of the American put price from European put-call parity, and in addition a theoretical estimate of the premium is computed. The empirically found premium is also used in a modied version of the control variate approach to value American puts. The results indicate a substantial value of the early exercise premium, where the premium derived from put-call parity is higher than the theoretical premium. The premium also increases with moneyness and time left to expiration, while the effect of interest rate and volatility depends on the moneyness of the option. The modied control variate technique works reasonably well relative to the theoretical models. In particular, for deep in-the-money options, this technique is superior. 2000 Elsevier Science B.V. All rights reserved.
JEL classication: G10; G13 Keywords: Early exercise premium; American put options; Modied control variate technique

1. Introduction The equity options traded on the Swedish exchange for options and other derivative securities, OM, are American options. They provide the option holder with the right to exercise the contract any time prior to expiration. The privilege to
* Corresponding author. Tel.: + 46-8-6747139; fax: + 46-8-153054. E -mail address: ln@fek.su.se (L. Norde n). 1042-444X/00/$ - see front matter 2000 Elsevier Science B.V. All rights reserved. PII: S 1 0 4 2 - 4 4 4 X ( 0 0 ) 0 0 0 2 5 - 6

462

M. Engstro m, L. Norde n / J. of Multi. Fin. Manag. 10 (2000) 461479

exercise early makes the prices of American options to include an early exercise premium compared to the prices of European options. Merton (1973a) shows that optimal early exercise never will occur for American call options written on non-dividend paying stocks. These calls could therefore be valued as if they were European, using, e.g. the Black and Scholes (1973) formula. When American call options on dividend paying stocks are concerned, early exercise might be optimal just before the ex-dividend instant. For an American put option on the other hand, early exercise may be optimal even if the underlying stock is not paying any dividends. In fact, an American put option should always be exercised early if it is sufciently in-the-money. The possibility of early exercise complicates the valuation of the American options, and several valuation approaches, both analytical approximations and numerical methods, have been developed. Examples of the rst category are Roll (1977), Geske (1979) and Whaley (1981) for call options and Geske and Johnson (1984) and MacMillan (1986) for put options. In addition, Barone-Adesi and Whaley (1987) analyse both calls and puts. Examples of the second category are Brennan and Schwartz (1977), Boyle (1977) and Cox et al. (1979). Blomeyer and Johnson (1988) compare the accuracy of the Geske and Johnson (1984) American option pricing model to the Black and Scholes (1973) European model for valuing equity put options traded on the Chicago Board Options Exchange (CBOE). They nd that both models undervalue options relative to market prices, but that the American model prices are much closer. They also reason that the difference between the deviation from market prices for the two models is an estimate of the early exercise premium. On average, this early exercise premium amounts to around 5% of the actual market price. Zivney (1991) argues that the American option pricing models do not value the early exercise premium appropriately, and suggests that the value of early exercise ought to be established empirically. In order to measure the value of the premium, Zivney examines deviations from European put-call parity (henceforth PCP) of the American S&P 100 index options traded on the CBOE. A deviation from PCP can be regarded as an approximation of the value of the early exercise potential for either the call or the otherwise identical put, depending on which one of them is in-the-money. Zivney also suggests that American options could be valued using a modication of the control variate technique (see e.g. Hull and White (1988)). In the modication, an empirical early exercise premium should be added to the theoretical value of a European option to obtain the American option value. Zivney (1991) discusses three different ways to establish the value of the early exercise premium. First directly, as the difference between otherwise identical American and European options, which is not possible in most markets. Secondly, as the difference between an American market price and a European value according to some option pricing model. Unfortunately, this will be a joint test of the premium and the accuracy of the chosen pricing model. The third way is to analyse deviations from PCP, and since this methodology does not rely on a specic option pricing model the problem of joint testing could be disregarded. However, the deviations from PCP could be due either to the early exercise premium or

476

M. Engstro m, L. Norde n / J. of Multi. Fin. Manag. 10 (2000) 461479

better for these options. Overall, the number of BAW control variate values within the bid/ask spread is rather close to the BAW model values. The values according to the different pricing approaches are also compared to the average of the daily closing bid/ask quotes of the options. In Table 5, the root
Table 5 RMSE for the difference between estimated option values and actual option prices, displayed with respect to moneyness and time to expirationa Time (days left) to expiration (Tt ) Moneyness (X /S ) 730 3190 91150 151182 Total

Panel A: option 6aluation using the PCP control 6ariate technique B0.90 0.3478 0.2995 0.4016 0.90-0.98 0.5010 0.4364 0.7577 0.98-1.02 0.3862 0.4590 0.7493 1.02-1.10 0.8808 0.9542 0.9001 1.10-1.20 1.3107 1.6613 1.5288 \1.20 1.7931 2.4059 3.2445 Total 1.1030 1.1830 1.2102 Panel B: option 6aluation using the BAW control 6ariate technique B0.90 0.4442 0.3720 0.3841 0.90-0.98 0.4497 0.3634 0.4991 0.98-1.02 0.0911 0.2474 0.3918 1.02-1.10 0.7406 0.7638 0.6427 1.10-1.20 1.2990 1.8979 1.6598 \1.20 2.6782 2.8229 3.9688 Total 1.4083 1.2964 1.2608 Panel C: option 6aluation using the BAW model B0.90 0.4423 0.3667 0.90-0.98 0.4509 0.3667 0.98-1.02 0.0807 0.2590 1.02-1.10 0.7191 0.6625 1.10-1.20 1.2163 1.6004 \1.20 3.2686 2.7594 Total 1.6383 1.1869 Panel D: option 6aluation using the BlackScholes model B0.90 0.4442 0.3819 0.900.98 0.4550 0.4061 0.981.02 0.1022 0.3282 1.021.10 0.8375 1.0484 1.101.20 1.7001 3.1130 \1.20 4.0104 4.5484 Total 2.0265 2.0640 0.4030 0.5001 0.3752 0.3985 1.2442 2.9014 0.9464 0.4557 0.5072 0.5123 1.1055 2.8515 5.7399 1.9458

1.5234 1.4788 1.1954 0.9014 1.8570 1.2303 1.0407 0.9647 0.6005 1.0213 1.8689 1.0182 1.0655 1.1269 0.7976 0.6384 1.1537 0.8673 0.7529 0.6912 0.4353 1.8593 2.5354 1.4588

0.3942 0.6894 0.6787 0.9104 1.5271 2.3156 1.1755 0.4101 0.4917 0.3425 0.7396 1.6608 3.0188 1.3014 0.4161 0.5107 0.3716 0.5835 1.3548 3.0704 1.2316 0.4341 0.4812 0.4021 1.1257 2.6920 4.5485 1.9805

a Panel A and B show the RMSE for the difference between the control variate option value, according to PCP and BAW, respectively, and the average of the closing bid and ask option prices. Panel C and D show the RMSE for the difference between the theoretical option value, according to the BAW model and the BlackScholes model, respectively, and the average of the closing bid and ask option prices. The observations are displayed with respect to moneyness and time to expiration.

M. Engstro m, L. Norde n / J. of Multi. Fin. Manag. 10 (2000) 461479

477

mean square error (RMSE) for the differences between theoretical values and average market quotes is presented for each pricing model. Panel A presents the RMSE for the PCP control variate approach whereas the results for the BAW control variate approach are reported in Panel B. The RMSE for values according to the BAW and the Black Scholes model are displayed in Panel C and D. Overall, the PCP control variate approach produces option values that minimise RMSE compared to the other approaches. The RMSE for all options in the evaluation sample is 1.18 for this approach, compared to 1.23 and 1.98 for the BAW and Black Scholes model, respectively. Again, this result is mainly due to a relatively better performance of the PCP control variate approach for deep in-themoney options with a short time left to expiration. As in Table 4, the results for the deep out-of-the-money options are similar for the different models, with the PCP control variate approach being slightly superior. The RMSE results for the BAW control variate model are rather close to the actual BAW model results. Surprisingly though, for the at-the-money options it outperforms the BAW model when it comes to RMSE. 6. Concluding remarks Using Swedish equity option data, this study analyses deviations from European put-call parity (PCP) to assess the early exercise premium in American put option prices. The empirically found early exercise premium is substantial and statistically signicant, with an average value of SEK 1.52 for the entire sample. This corresponds to around 9% of the average market price for the put options. For comparison, a theoretical early exercise premium, computed as the difference between the values given by the BAW and the BlackScholes model, is also analysed. The value of the theoretical premium, which is SEK 1.06 (roughly 7% of the BAW value) on average, is signicantly lower than the premium according to the deviations from PCP. Since the average option price is lower for the theoretical model, this could imply that some of the mispricing of the theoretical model is explained by incorrect valuation of the early exercise premium. As expected, the value of the premium, obtained from PCP, is found to increase with the moneyness of the options and with the time left to expiration. The effect of the volatility and the interest rate however, is not as clear. Regression results show that for out-of-the-money and at-the-money options, the effect is as hypothesised. For in-the-money options however, the relationship between premium and volatility is negative, and also the interest rate coefcient has a negative sign. In a 1-month evaluation period following the estimation period, the regression coefcients from the estimation period are used to obtain the early exercise premium. This premium is added to the option price given the BlackScholes model, in a modied version of the control variate approach to value American puts. Although clearly not perfect, this technique works reasonably well, especially for the deep in-the-money options with a relatively short time left to expiration, where it is superior compared to the other models. A possible explanation is that the theoretical models undervalue the early exercise premium for these options.

478

M. Engstro m, L. Norde n / J. of Multi. Fin. Manag. 10 (2000) 461479

The comparatively high premium that is found in this study is interesting. The results of Engstro m et al. (2000) show that a large number of put options are not exercised when they should be. It appears that the Swedish option holders are more inclined to pay a premium for the right to exercise their contracts early, than to actually exercise the contracts.

Acknowledgements This study has beneted from comments and suggestions from an anonymous referee, Niclas Hagelin and seminar participants at Stockholm University, the 1999 Workshop on Empirical Finance in Vasa, and the 12th Annual Australasian Banking and Finance Conference in Sydney. We would also like to thank Anders Stro mberg at OM Stockholm AB for his assistance. Financial support from Bankforskningsinstitutet for the rst author is greatly acknowledged.

References
Barone-Adesi, G., Whaley, R., 1987. Efcient analytic approximation of American option values. J. Financ. 42, 301320. Belsley, D., Kuh, E., Welsch, R., 1980. Regression Diagnostics, Identifying Inuential Data and Sources Of Collinearity. Wiley, New York. Black, F., Scholes, M., 1973. The pricing of options and corporate liabilities. J. Polit. Econ. 81, 637 657. Blomeyer, E., Johnson, H., 1988. An empirical examination of the pricing of American put options. J. Financ. Quant. Anal. 23, 1322. Boyle, P., 1977. Options: a Monte Carlo approach. J. Financ. Econom. 4, 323 338. Brennan, M., Schwartz, E., 1977. The valuation of American put options. J. Financ. 32, 449 462. Brenner, M., Galai, D., 1986. Implied interest rates. J. Business 59, 493 507. Cox, J., Ross, S., Rubinstein, M., 1979. Option pricing: a simplied approach. J. Financia. Econom. 13, 145 166. Dawson, P., 1994. Comparative pricing of American and European index options: an empirical analysis. J. Futures Markets 14, 363378. deRoon, F., Veld, C., 1996. Put-call parities and the value of early exercise for put options on a performance index. J. Futures Markets 16, 71 80. Engstro m, M., Norde n, L., Stro mberg, A., 2000. Early exercise of American put options: Investor rationality on the Swedish equity options market. J. Futures Markets 20, 167 188. Evnine, J., Rudd, A., 1985. Index options: the early evidence. J. Financ. 40, 743 756. Geske, R., 1979. A note on an analytical formula for unprotected American call options on stocks with known dividends. J. Financ. Econom. 7, 375 380. Geske, R., Johnson, H., 1984. The American put valued analytically. J. Financ. 39, 1511 1524. Hull, J., White, A., 1988. The use of the control variate technique in option pricing. J. Financ. Quant. Anal. 23, 237251. Jorion, P., Stoughton, N., 1989. An empirical investigation of the early exercise premium of foreign currency options. J. Futures Markets 9, 365 375. Jorion, P., Stoughton, N., 1990. The valuation of the early exercise premium in the foreign currency options market. In: Khoury, S. (Ed.), Recent Developments in International Banking and Finance 3. Probus Publishing, pp. 159190. Kamara, A., Miller, T., 1995. Daily and intradaily tests of European put-call parity. J. Financ. Quant. Anal. 30, 519539.

M. Engstro m, L. Norde n / J. of Multi. Fin. Manag. 10 (2000) 461479

479

MacMillan, L., 1986. Analytic approximation for the American put option. Adv. Futures Options Res. 1, 119 139. McMurray, L., Yadav, P., 1996. The Early Exercise Premium In American Option Prices: Direct Empirical Evidence, Chicago Board of Trade Eight Annual European Futures Research Symposium Proceedings. Merton, R., 1973a. Theory of rational option pricing. Bell J. Econom. Manage. Sci. 4, 141 183. Merton, R., 1973b. The relationship between put and call option prices: comment. J. Financ. 28, 183 184. Roll, R., 1977. An analytical valuation formula for unprotected American options on stocks with known dividends. J. Financ. Econom. 5, 251 258. Stoll, H., 1969. The relationship between put and call option prices. J. Financ. 24, 801 824. Unni, S., Yadav, P., 1998. Market Value Of Early Exercise: Direct Empirical Evidence From American Index Options, Discussion Paper no 5. Centre for Financial Markets Research, University of Strathclyde. Whaley, R., 1981. On the valuation of American call options on stocks with known dividends. J. Financ. Econom. 9, 207211. White, H., 1980. A heteroscedasticity-consistent covariance matrix estimator and a direct test for heteroscedasticity. Econometrica 48, 817838. Zivney, T., 1991. The value of early exercise in option prices: an empirical investigation. J. Financ. Quant. Anal. 26, 129138.