What is the Value of Being American?

The S&P 100 index trades both European and American options. We exploit this relatively unique feature to empirically investigate the early exercise premium (“EEP”) in American put option prices. We provide direct evidence that the American style exercise creates a transaction cost saving option, which generates a significant EEP by incentivizing and rewarding early exercise of American options that would alternatively have been “sold” in the market. After duly accounting for the market implied value of the wild card option, we find that, while jump models fit observed EEP better than other model types, even jump models consistently and significantly underprice observed EEP. We empirically estimate the EEP that arises from this transaction cost savings option, and find that it is a significant determinant of virtually all the observed overpricing of market EEPs relative to their model-based values. We further use a natural experiment – the exogenous variation of transaction costs during the Bear Stearns bailout – to show that the transaction cost saving option is the principal reason why market EEPs are larger than model-predicted EEPs and wild card premia combined