Does the Early Exercise Premium Contain Information about Future Underlying Returns?
Speaker
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. 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, rather than other components of unexpected returns. Overall, we use several empirical and simulation methods to establish predictability of the underlying with an options market variable, link this predictability to information about cash flow fundamentals, and thereby provide clear support for Black’s (1975) conjecture that informed investors prefer to trade on their superior information about fundamentals in the options market relative to the underlying. |
| The Erasmus Finance Seminar is jointly sponsored by ERIM and the Tinbergen Institute. |
| Contact information: |
| Viorel Roscovan |
