Conference Program

Early Warning Signals from Early-Exercise Premia (310089)

Stephen Karolyi, Office of the Comptroller of the Currency 
*Ricky Rambharat, Office of the Comptroller of the Currency 
Yu Man Tam, Office of the Comptroller of the Currency 

Keywords: Option, American, European, Put, Implied volatility, Early Exercise Premium, Warning, Signal, Statistical Process, Control chart

This study proposes the use of discrepancies in the implied volatility (IV) between American and European style options. The holder of an American-style option has the right, though not the obligation, to buy (a Call option) or sell (a Put option) a share of an underlying asset at a fixed price (the strike price, K) at any time point between the onset of the option contract and the expiration (T). European-style option contracts are similarly defined, but the transaction (exercise) opportunity can only occur at the expiration time T of the option. An American option is more valuable than its European counterpart with the difference defined as the early-exercise premium (EEP). The S&P 100 Index is one example of an underlying asset on which BOTH American and European option contracts are written, which is rare, but this makes the IV and EEP directly observable. The first part of our study uses the S&P 100 Index option data to uncover how anomalous IV deviations affect the EEP for Put options since these options can be analyzed to foreshadow potential volatility. We propose a lemma that establishes the IV and EEP as early warning distress signals based on Put options, leveraging earlier theoretical results on Put options as well as Put-Call parity results. We find that the aforementioned EEP deviations arise from statistical inconsistencies in the IV, and we study how to quantify potential arbitrage effects. We also apply Statistical Process Control charts to empirically justify our claim establishing the maximum daily IV discrepancy as a possible monitoring metric. These maximal IV discrepancies can be linked to not only effects on the EEP (based on option moneyness and maturity), but also market volatility for which we use the VXO (the volatility index on the S&P 100). We assert that this procedure can uncover arbitrage effects, which, although short-lived, may result in profit. This work motivates further studies in cases where only American options are available.