Do Transaction Costs Affect the Optimal Exercise Strategy for American Put Options?

Abstract

Empirical evidence shows that American put options are exercised less often than predicted by theory. The paper provides an explanation for this empirical phenomenon by analyzing the effect of transaction costs in the underlying on the optimal exercise strategy. Using a model which explicitly takes transaction costs into account, we show for a realistic parameterization that it maybe optimal to postpone the exercise of put options relative to the standard frictionless theory. This result is mainly driven by the fact that transaction costs increase the replication costs associated with the payoff of a put option, i.e., transaction costs increase the continuation value of a put option which leads to a smaller number of states in which exercising is optimal.

Keywords: American Options, Transaction Costs, Optimal Exercise Strategy, Discrete Binomial Setup, Small Proportional Transaction Costs

JEL Classification: G13