Does the Early Exercise Premium Contain Information
TITLE: Does the Early Exercise Premium Contain Information about Future Underlying Returns?
SPEAKER: Dr. Yuzhao Zhang
Fox School of Business
We investigate the information content of the call (put) Early Exercise Premium, or EEP, defined as the normalized difference in prices between otherwisecomparable American and European call (put) options. The call EEP specifically captures investors expectations about future lump sum dividend payments aswell 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 exceptionin 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 Americanand European options contracts, from which we compute a time series of the EEP. the dynamics of the EEP. We use simulations to show that these empiricalfindings 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, 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 aboutcash flow fundamentals, and thereby provide clear support for Blacks (1975) conjecture that informed investors prefer to trade on their superior informationabout fundamentals in the options market relative to the underlying.
Dr. Yuzhao Zhang is currently an Assistant Professor of Finance in the Fox School of Business at the Temple University. He earned his PhD in finance from the University of California Los Angeles in 2008, an M.S. of mathematics in finance from the New York University in 2002. His research interests include asset pricing, financial econometrics and derivatives. He teaches courses in investments and portfolio theory. He presented his work at University of California Los Angeles, New York University, Temple University, University of Hong Kong, Singapore Management University, Peking University, and European Finance Association Annual Meeting.