Does the Early Exercise Premium Contain Information About Future Underlying Returns?
46 Pages Posted: 5 Aug 2005 Last revised: 8 Jan 2022
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: Suggested Citation