Why are the prices of European‐style derivatives greater than the prices of American‐style derivatives?

Abstract

The prices of European‐style derivative warrants in Hong Kong are generally higher than those of identical American‐style options. We show that liquidity differences have strong explanatory power for this overpricing behavior, especially for low moneyness and long‐term derivatives. Other causative factors include counterparty credit risk, investor preference, information asymmetry, volatility discovery, exercise style, market makers' behavior, and investor sentiment. We also find a big gap in market‐wide liquidity between the two markets. Specifically, lower liquidity results in the weaker efficiency of the options market compared with the derivative warrants market.

An empirical study on the early exercise premium of American options: Evidence from OEX and XEO options

“…First, more overvalued situations might be considered if employing the intraday data. Then, as documented in previous literature (e.g., Battalio et al, 2020;Deuskar et al, 2011;Jin et al, 2022), the trading details like buy, sell, and exercise behavior, which can reflect the rationality of investors as well as the inventory risk of liquidity providers, pose great influences on the EEP in derivative markets. Third, since we employ the bid-ask spreads as a liquidity proxy, it is more appropriate to measure the effective bid-ask spread in the option market.…”

“…Following this method, the premiums of OEX and XEO options are standardized by the underlying and expressed in terms of the percentage of the S&P 100 Index level. Li and Zhang (2011) and Jin et al (2022) argue that the liquidity difference can have strong explanatory power for overpricing behavior, especially for low moneyness derivatives. Both investigate the price differences between warrants and options, and find a large gap in liquidity between the two markets that lower liquidity results in the weaker efficiency on asset pricing.…”

“…and the negative remaining EEP. Several studies (Battalio et al, 2020;Jin et al, 2022;Li & Zhang, 2011) use OI and TO to denote the preferences of investors. Following previous studies, we define OI as the difference between the daily open interest of OEX and equivalent XEO options…”

“…The S&P 100 Index underlies both American (OEX) and European (XEO) options, making it a clean and fertile land to analyze the premium difference between options with two different exercise styles. The valuation differences between American‐style and European‐style derivatives have been widely researched, while these studies either cannot directly collect the EEP from the market, they instead derive the EEP from models (e.g., Figlewski, 2022) or compare different derivatives with different exercise styles (e.g., Jin et al, 2022; Li & Zhang, 2011). We find that the EEP of an American option is not always positive.…”

“…Third, our findings contribute to previous studies on the comparison of prices of derivatives. For instance, Li and Zhang (2011) emphasize the price difference between European‐style warrants and options, and Jin et al (2022) focus on European‐style warrants and American‐style options. We extend these papers by investigating the same derivatives with different exercise styles based on the unique feature of S&P 100 Index options market.…”