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An American Call Is Worth More Than a European Call: The Value of American Exercise When the Market Is Not Perfectly Liquid

Published online by Cambridge University Press:  20 April 2021

Stephen Figlewski Open the ORCID record for Stephen Figlewski [Opens in a new window]
Stephen Figlewski*
Affiliation:
New York University Stern School of Business
*
[email protected]
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Abstract

Theory says an American call should never be exercised early, except possibly just before an ex-dividend date. But the best market bid is regularly lower than the intrinsic value for in-the-money short-maturity options. An American option can always be exercised to recover the intrinsic value, whereas selling a European call in the market may return considerably less. The article derives the liquidity value of American exercise in closed form as a function of the bid–ask spread and shows empirically that it is of comparable magnitude to, and often greater than, the theoretical value of American exercise to collect a dividend.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 57 , Issue 3 , May 2022 , pp. 1023 - 1057
Copyright
© The Author(s), 2021. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

I thank Richard Xu for able assistance on an earlier draft and the NASDAQ Educational Foundation for financial support. I am grateful for comments from Rob Neal, Scott Murray, Neil Pearson, Pascal François, and especially the referee, as well as participants at the 2018 Canadian Derivatives Institute Conference, the 2017 Derivatives and Volatility Conference at New York University (NYU), and seminars at the Instituto Tecnológico Autónomo de México (ITAM), Florida International University, Auburn University, Georgia State University, the University of Massachusetts, Lord Abbett, the University of Manchester, University College Dublin, and the University of Sussex.

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