Does the Early Exercise Premium Contain Information About Future Underlying Returns?

46 Pages Posted: 5 Aug 2005 Last revised: 8 Jan 2022

See all articles by Rossen I. Valkanov

Rossen I. Valkanov

University of California, San Diego (UCSD) - Rady School of Management

Yuzhao Zhang

Rutgers, The State University of New Jersey - Department of Finance

Pradeep K. Yadav

University of Oklahoma Price College of Business

Date Written: October 14, 2018

Abstract


We investigate the information content of the call (put) Early Exercise Premium, or EEP, defined as the normalized difference in prices between otherwise comparable American and European call (put) options. The call EEP specifically captures investors’ expectations about future lump-sum dividend payments, as well as other state variables such as conditional volatility and interest rates. From that perspective, the EEP should also be related to future returns of the underlying security. Little is known about the EEP, largely because it is usually unobservable for most underlying securities. The FTSE 100 index is an exception in that regard, because it has both American and European options contracts that are traded in large volumes. We use data of the FTSE 100 index, and its American and European options contracts, from which we compute a time series of the EEP. We use simulations to show that these empirical findings can be explained with a realistically calibrated dividends process with lump-sum payments. Interestingly, we find that the EEP is a good forecaster of returns at daily horizons. This forecastability is not due to time-variation in market risk premia or liquidity. Importantly, we find that the predictability stems primarily from the ability of the EEP to forecast innovations in dividend growth and macroeconomic conditions. Overall, we use several empirical and simulation methods to establish predictability of the underlying with an options market variable and to link this predictability to information about market-wide cash-flow fundamentals and macroeconomic conditions.

Keywords: Return Predictability, Early Exercise Premium, Dividend Growth

JEL Classification: G12, G13, G14, G15

Suggested Citation

Valkanov, Rossen and Zhang, Yuzhao and Yadav, Pradeep K., Does the Early Exercise Premium Contain Information About Future Underlying Returns? (October 14, 2018). Available at SSRN: https://ssrn.com/abstract=769144 or http://dx.doi.org/10.2139/ssrn.769144

Rossen Valkanov (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858-534-0898 (Phone)

Yuzhao Zhang

Rutgers, The State University of New Jersey - Department of Finance ( email )

94 Rockafeller Road
Piscataway, NJ 08854
United States

Pradeep K. Yadav

University of Oklahoma Price College of Business ( email )

307 W.Brooks, Room 3270 Division of Finance
Norman, OK 73019
United States
4053255591 (Phone)
4053255491 (Fax)

HOME PAGE: http://www.ou.edu/price/finance/faculty/pradeep_yadav.html

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