Working Paper: CEPR ID: DP11019
Authors: Lasse Heje Pedersen; Mads Vestergaard Jensen
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
JEL Codes: G11; G12; G13; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| short-sale costs (G33) | early exercise (Y60) |
| transaction costs (D23) | early exercise (Y60) |
| funding costs (G32) | early exercise (Y60) |
| financial frictions (G19) | early exercise (Y60) |
| short-sale costs (G33) | early exercise rates for convertible bonds (G12) |
| stock price above exercise boundary (G13) | early exercise (Y60) |
| stock price below exercise boundary (G13) | early exercise (Y60) |