The rationality of early exercise decisions: evidence from the S&P 100 index options market

This study provides a comprehensive empirical analysis of theearly exercise history of S&P 100 put and call option. Eventhough the S&P 100 index option market is generally consideredto be the most efficient options market in the world, we showthat many exercise decisions are inefficient because they occurwhen recorded bids are greater than exercise values. Due tomarket imperfections, some of the cases of inefficient exerciseare still rational, but we show that a substantial number ofthese decisions are clearly irrational since it would have beenpossible to realize a larger riskless net cash flow by selling.Unlike previous studies of early exercise, our tests of efficiencyand the rational decisions that presumably lead to efficientmarkets are model independent. We also provide evidence concerningthe relative significance of dividends and the wild card toindex option pricing models, and introduce and document theimportance of the option to exercise and avoid the indirectcosts of the spread. We also find evidence of a significantday-of the-week exercise effect, and present some likely explanationsfor that effect.