Exercise Boundary Violations in American-Style Options: The Rule, not the Exception

Abstract

An exercise boundary violation (EBV) occurs when the current bid price for an American option in the market is below intrinsic value. A seller at this price leaves money on the table and the buyer receives an arbitrage profit. In a liquid market, competition among dealers should drive up the bid prices and eliminate the arbitrage. An analysis of intraday data shows that EBVs are the norm, not the exception, with near-term in-the-money equity calls and puts the most affected. In March 2010 48.6% of all in-the-money call options had EBV bid quotes and 11.5% of trading volume in those options occurred below the intrinsic value, costing the sellers an estimated $39 million. EBVs are highly persistent throughout the day, making it rational to liquidate an option by exercise rather than selling it in the market, in sharp contrast to textbook theory. Our empirical results show early exercise is strongly related to an option's EBV. In addition to altering optimal exercise strategy and the value of the early exercise premium, the possibility of early exercise to avoid an EBV makes intrinsic value the effective bid price. This narrows the spread and raises its midpoint, which affects customary measures of market liquidity, the option's market price, and its implied volatility.