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Clearly Irrational Financial Market Behavior: Evidence from the Early Exercise of Exchange Traded Stock Options

Authors

  • Allen M. Poteshman,

  • Vitaly Serbin

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    • *Poteshman is from the Department of Finance, College of Commerce and Business Administration, University of Illinois at Urbana-Champaign. Serbin is from the Department of Finance, College of Commerce and Business Administration, University of Illinois at Urbana-Champaign and ITG Inc. in Boston, MA. We thank Joe Levin, Eileen Smith, and Dick Thaler for assistance with the data used in this paper. We are grateful for helpful comments from Louis Chan, Jenny France, John Griffin, Mike Hertzel, Josef Lakonishok, Inmoo Lee, Spencer Martin, Bob McDonald, an anonymous referee, and seminar participants at Arizona State University and the University of Notre Dame. The suggestions of Rick Green (the editor), George Pennacchi, and Mike Weisbach were especially helpful in improving the paper. We bear full responsibility for any remaining errors.

Abstract

This paper analyzes the early exercise of exchange-traded options by different classes of investors over the 1996 to 1999 period. A large number of exercises are identified as clearly irrational without invoking any model of market equilibrium. Customers of discount brokers and customers of fullservice brokers both engage in a significant number of irrational exercises while traders at large investment houses exhibit no irrational early exercise behavior. Rational and irrational exercise is triggered for discount and full-service customers by the underlying stock price attaining its highest level over the past year and by high returns on the underlying stock.

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