Journal of Financial Economics 23 (1989) 339-361.

Not-t ollan

Gerald
Georgiu Stute Universit,: A tluntu, GA 30303, USA

obert
Universip of Miumi, Corul Gables, FL 33124, USA

enneth YUNG
Georgia Stute Universit): A tluntu, GA 30303, USA
Old Dominion Universitry. Norfolk, VA 23508, USA

Received July 1988, final version received January 1989

We examine the rationality of investor exercise behavior by analyzing two years tendered exercise
notices for Treasury bond futures options. We concl..de that exercise behavior is generally
rational, but document numerous failures to exercise as well as some exercises that should not
have occurred. both at and prior to expiration. The most frequent type of error is failing to
exercise, suggesting that traders do not monitor their positions with sufficient care. Finally. we
show that investors use information arriving after trading close>, but before exchange-imposed
exercise deadlines, in forming their exercise decisions.

Rules for the optimal exercise of American options are well known. but
little is known about how closely traders follow these rules. o detcrmine how
well practice corresponds to policy, we document investor xercis: behavior
for Treasury bond futures options, both at and prior to expiration.
examine the complete daily record of tendered exercise notices, disaggregate

*We have benefited from discussions with Bob Wha

Rutz (President of the Chicago Board of Trade Clcarin
in the Georgia Tech Finance W
Richard Ruback, and the referee,
Futures Trading Commission for
Chicago Board of Trade
Research Council, Georgia

ncs various mo
348 G. Guy et ul., Rutiomli(v irrthe exercise of futures optiom

by option maturity and exercise price, for all contracts maturing during
19854986.
n a study of q&y option returns around ex-dividend dates, Kalay and
Subrahmanyam (1984) recognize the importance of rationality in early exer-
cise. Assuming rational exercise by traders, they argue that American call
options should behave no differently ex-dividend than on other days.
ever, they report significantly negative excess returns during the cum-ex-
dividend interval for a sample of options that should have been exercised,
sting irrational behavior.
r study has a different focus. We examine the rationality of exercise
behavior directly. The analysis of exercise behavior for futures options is
interesting, because these options have greater potential for early exercise than
do equity options. For equity options, rational early exercise can occur only on
the last cum-dividend date for the underlying equity, or on a maximum of
three dates. For futures options, however, rational early exercise can occur on
any day of the options life. Futures option s therefore, provide a rich sample
of observations for an analysis of rationality.2
We define irrational- exercise decisions to include notices tendered when
they should not have been as well as failures to exercise. We also distinguish
between the time when an option expires and the time before expiration. This
distinction is important becaus; at expiration, the exercise decision depends
only on the strike price and the price of the underlying good. Before expira-
tion, by contrast, the exercise decision implicitly rests on a model of the true
option value or on an estimate of the proceeds to be realized by holding the
underlying asset. For option values, we rely on the Barone-Adesi and Whaley
(1987) model for American futures option pricing, which, in addition to
computing put and call values, allows for explicit determination of a critical
futures price for an option. The critical futures price is the price at which the
option holder is indifferent between holding and exercising the option. In the
arone-Adesi and Whaley model, the call should be exercised immediately if
and only if the futures price exceeds the critical futures price. An analogous
rule applies for puts. Consequently, the model provides definitive rules for
rational exercise behavior.
ules of the clearing corporation complicate the analysis of rationality by
ctively causing traders to make exercise decisions after the market closes.
cn the market is closed, the decision to exercise depends on the traders
beliefs about the prevailing, yet unobservable, equilibrium futures price. The
closing or settlement price may not be the best proxy for the equilibrium
futures price when the exercise decision is made, particularly when infnrma-
tion arrives after the close of the marke but before clearing corporation

Galai (1978) presents analysis similar in spirit to that conducted here Specifically. hc tests
whether equity cqtion prices conform to derived loticr-boundary conditions.
 G. Gay et al., RatioHah[v in the exercise of futures optiom 341

deadlines for tendering exercise notices. ccordingly, we consi

proxies for the equilibrium futures price and co pute dollar losses from faulty
exercise behavior for each proxy.
The paper is organized as follows. Section 2 presents conditions
exercise and the corresponding loss measures for both faulty exercises and
failures to exercise. Although we develop the analysis specifically for T-bond
futures options, it may be generalized to any futures options. Section 3
introduces the data we use and presents summary s istics on the observed
exercises. These statistics indicate that exercise is w read; over the two
years studied, nearly 700,000 ccntracts are exercised. er, the data reflect
disagreement among traders about appropriate exercise behavior. Section 4
presents our main results on the historical exercise behavior of T-bond futures
options. Although we find historical exercise behavior that is broadly consis-
tent with rationality, we document numerous instances of failure to exercise
and a smaller number of faulty exercises both at and before expiration. The
errors at expiration are particularly striking, both because they can be com-
puted directly and because they are large in relation to potential transaction
costs. Prior to exercise, the most common error is failure to exert
ing that traders do not monitor their positions with sufficient care. In addition,
we show that investors use information arriving after the close of the market
but before the clearing corporations deadline for tendering notices. Section 5
summarizes the study.

ptimal exercise

2.1i Exchange procedures forexercise

The T-bond futures option contract trades on the floor of the Chicago
Board of Trade (CBOT) in the March, June, September, and December
maturity cycle.3 Trading in the three nearby contract maturities is conducted
at any one time. The last day of trading for the futures option is the Friday
that precedes the first notice day of the underlying futures contract by at least
five business days. Before the arch 1987 contract
automatic exercise at expiration. Currently, the
automatically if it is at least one days li it move in-the-
explicitly instructed otherwise. Given a typical daily pri
this contract, however, the policy effectively requires tr

3We are indebted to Roger

tion, for insights into actual practices in t
342 G. GU_V
et al.. Rationali!v in the exercise of futures options

option position closely. 4 Before the last trading day, exercise occurs only by
explicit instruction.

2.2. Conditions for optiml exercise

Because most traders wait until 8 p.m. to exercise their options, the
equilibrium futures price at the time of exercise is not observable and may
differ frrPm the settlement price Sixed at 2 p.m. We therefore consider three
proxies for the equilibrium price that prevails at 8 p.m. on a given trading
day:

SETTLE: Treat Fs, the settlement price, as the proxy for the equilibrium
futures price at the time of the exercise.
OPEN: Treat Fo, the next trading days opening price, as the proxy for
the equilibrium futures price at the time of the exercise.
BEST: Use whichever price, Fs or F,, is more consistent with rationality
as the proxy for the equilibrium futures price at the time of the
exercise.

At expiration, rational exercise depends only on the exercise price of the

option and the price of the underlying good. The first three rows of table 1,
corresponding to the three proxies of the equilibrium futures price at expira-
tion, specify the exercise conditions for calls at expiration and show the losses
from incorrect exercise decisions. For example, in row 1, using the settlement
price as the proxy (SETTLE), one should exercise a call if F, > X (where X
denotes the exercise price), and the loss from not exercising is Fs - X.
Similarly, one should not exercise if F, < X, and the loss from exercising is
X - F,. Rows 2-3 present the same information for the other two proxies,
OPEN and BEST. Rows 4-6 present the corresponding conditions and loss
computations for puts at expiration.
Before expiration, the exercise conditions are more complicated. As Whaley
(1986) discusses, the value of an American futures option equals the value of a
corresponding European futures option plus an early exercise premium. As F
becomes large in relation to X, the value of the European futures call
approaches (F - X)e-, where Y is the riskless rate of interest and t is the
time remai,ilng until expiration. The owner of an American futures call,

4This contrasts significantly with rules practiced for equity options in which automatic exercise
occurs for options held by regular customers that are 3/4 of a point in the money and l/4 of a
point for options held by member firms and market makers.
The beginning of evening trading on the Chicago Board of Trade on April 30. 1987 makes it
possible to UK market prices from the evening hours to test exercise behavior. The beginning of
evening trading, however, postdates the period cxamincd in this study.
 Table 1
Treasury bond futures option exercise conditions and loss measurements from errant exercise behavior for three equibrium futures price proxies.
Fs is the current days futures settlement price, Fo is the next days opening futures price, I;* is the critical futures price. for a call, F** is the critical futures
l
price for a put, X is the exercise price, r is the daily interest rate, and P( a) and C( ) refer to the put and call values. respectively.
_ -_-_---- ~- --
Should exercise Should not exercise
Futures _.--- ---
price Condition for Loss from not Condition for not Loss from
RWV proxy a exercising exercising exercising exercising
-_ -- I__-~--
Culh (1t expiru Ii011

(1) SETTLE ,As> x 54 - X &j < X X- Fs

0) OPEN F, > X F, - X F, =c X X- F,

(3) BEST mirl( Fs, F,) > X min( Fs, F,) - X max( F,, Fo) < X X - max( Fs, F,)
-----~--- --- _~.~
Puts ut e>_-pirutiort

(4) SETTI,E Fs < X X- 6 F, > X & - X

(5) OPEN FO < X X- F, F, > X Fo - x

(6) BEST max( Fs. Fo) < X X - max( Fs. FG) min( F,, F, ) > X min( Fs, FO) - X
____-- Lo --~
Culls prior to espirutiorl

(7) SETTLE Fs > F* (F, - X)r Fs < F* C(F,)-( cs- X)

(8) OPEN Fs > X and (F, - X)r Fs < Xor C(F,)--[(F,- X)(1 +rIi-(JLo- &)I
F, > FL FO =c F*

(9) BEST min( Fs, FO ) > F* ( Fs - X)r min( F,, F,) < X min{C(Fs)-(Fs- X))or
{C(Fo)-I(& - X)(1 + r) + ( 6.i. - &)I)
_- ---
Puts prior to expirutiori

(10) SETTLE F,cF** (X- Fs)r Fs > F** f(F,) - (X- Fs,

(11) OPEN F, =z X and (X- F,)r Fs> Xor W&4(X- &Ml +r) +(&-WI
F, < F** F, > F**

(12) BEST max( Fs. Fo) < X (X-F,)r max( Fs. F,) > F** min{P(Fs)-(X- F,)}or
{ 0 Fi) - [( X - FsM1 + 0 + ( Fs - F&l}
-- ~---
SETTLE refers to analyzing exercise behavior based on the 290 p.m. futures settlement price; OPEN refers to analyzing exercise behavior based on the next trading :
days opening futures price; and BEST refers to analyzing exercise behavior based on the most favorable of the two prices for the hypothesis of rational exercise.
 G. Guy et al., Ruiiomli[rl irt the exercise of futures optiom

n the critical fut

uld exercise the call, collect the exert

given by

, t; X) +A,(F/F*)42 where F< F*,

=F-x where F 2 F*,

where
= ( F*/q,){ 1 - e-W[dl( F*)]},
= ln( F/X) -I- o.so*t]/[
.2t]o*5,
- [I + (; + Gk )]/2,

2v/[s(I - P)],
=

= instantaneous variance of t e futures price changes.

*, is determined iteratively by solving

*- *, t; X) + (1 -esW[d,(F*)]}F*/q2.
s, with the quadratic approximation

**
) where 6:>

ed to valuing T-bond futures options. assumes a

ormal futures price. Courtadon (1983) and
uation models for futures options that employ
valuation model for the underlying
sls of T-bond futures prices do not
 1

1
F** = critical futures pr below which t
which is determin iteratively by s
(1

e use the model to evaluate the exercise con

with exercise errors prior to expiration for each o
e~~uilib~~~rnfutures price. example, in row 7 of
should be exercised if Fs, settlement price, is
futures price. For a ven day, if the call should
call owner loses one days interest on the exe
expected loss equals only one days interest
the next day, assuming that tomorrows expect
alogously, if F, < F* and the call is exercised a
C( F,) - (F, - A), where C(e) denotes the value of an
option In s case, exercise causes loss of the difference between the v:2lue of
the call an ts intrinsic value.
ow 8 of table 1 shows the corresponding conditions an loss computations
using Fo as th Y). These differ arkedly from the previous result,
because cash epend on F,, bu the equilibrium futures price is
measured as Fo. As row 8 shows, a trader should exercise a call if and only if
there are both exercisable proceeds (F, > X) and the equilibrium futures price
exceeds the critical futures price (Fo > F*). The less from not exercising is stir1
(F,- X)r - one days interest on the exercisable procee
sider the position of an investor who does not exercise.
the next day, the trader still holds a call with a value of F, - X, because
F, > F*. IIf there is an exercise, the investor surrenders the call, but receives

ow 8 of table 1 al
exercised if there are n
346 G. Guy et ui., Rutionuli~r-lill the exercise of futures optiorrs

overnight on the lo ow 9 of table 1 corresponds to the

conservative proxy ( using whichever price, Fs or Fo, is more consistent
with rationality. LJ sider exercise behavior rational if it
would be rational using either ehavior is still fou
e minimum of the losses associa
e expiration, rows 10-12 show
s and correspond to rows 7-9 in
structure.

3. I. The data
This study focuses on the eight T-bond futures maturities occurring between
arch 1985 and ecember 1986, and on the futures options traded on those
OT), we obtain daily settle-
he futures option contracts,
as well as volume and open interest figures for the futures options. These data
cover the entire tr ng history of each contract, so our data extend from May
25, 1984 for the rch 1985 contracts until the December 1986 contracts
mature on November 15, 1986. e obtain data on actual exercise behavior for
rice and contract maturity from the Commodities Futures Trad-
ion. We supplement the futures prices and exercise records with
reports from the C T to build a complete daily record of all exercises of all
options on the contracts over their entire trading lives. In addition, for each
day, we collect interest-rate data from the Wall Street Journal, based on the
mean of the bid and asked quotations for the T-bills maturing closest to each
0 's expiration day.

ut and call summary statistics

statistics for exercises of T-bond futures options.

there were nearly 700,000 exercises, with calls
ore than half of all exercises occurred before
expiration and these early exercises were distributed over many different days.
1986 contract had the most concentrated exercises
but exercises still occurred on 21 different days.
exercises before expiration, early exercise is a
T-bond rutures options market. n results not

ered two akrnatide measures of the loss from faulty exercise based on Fo:
Fa - &)/(I 4 !.)j.
scrvative 10~5e5ti
 e2
Sutmmary of Treasury bond futures option exercises over lifeti
1985-1986.
- -__c_ -

Number of
calendar days Percent of open
Number of exercises interest exercisedd
on which
Contract - At Prior to exercise
maturity Total expiration expiratio# occurred
- -_-____
CL&
Mar. 85 17,764 7.566 10,198 49 100 8 92
Jun. 85 57,744 38,389 19,355 29 60 10 50
Sep. 85 38,715 6,975 31,740 41 92 7 85
Dec. 85 65,942 26,506 39,436 35 77 6 71
Mar. 86 133,943 51,636 82,307 57 159 12 147
Jun. 86 136,950 8,867 128,083 75 303 15 288
Sep. 86 71,061 25,810 45,251 69 173 25 148
Dec. 86 51,793 46,515 5,278 21 36 12 24
Subtotal 573,912 212,264 361,648 376 l.OOU 95 905

Puts
Mar. 85 17,212 16,930 282 9 11 3 8
.
Jun. 85 293 89 204 6 7 5
Sep. 85 13,362 12,299 1,063 18 23 ; 20
Dec. 85 6,945 5,279 1,666 6 7 2 5
Mar. 86 472 5 467 5 6 2 4
Jun. 86 51.126 34,767 16,359 7 21 6 15
Sep. 86 13,323 12,921 402 3 5 2 3
Dec. 86 10.495 8,454 2,041 9 19 4 15
Subtotal 113,228 90,744 22,484 33 99 24 75

Tot&
687,140 303,008 384,132 439 1,099 119 980

ZAt expiration refers to all exercises on and following last day of trading.
Prior to expiration refers to all exercises prior to last day of trading.
4 contract day is defined as a day on which a particular option of a given expiration and exercise
price is available for trading. A calendar day invoilves several contract days.
dFor days on which the exercise of a particular contract occurs, this statistic indicates whether all
2:00 p.m. open interest in that contract is exercised (100%) or not ( < 1;30%).
348 6. Guy et ul., Ratiorralrtyirt the exercise of futures opticws

lthough the first four columns of table 2 consider options disaggrepnted

only by expiration, the last three columns report exercise behavior d%aggrc-
both expiration a
s with different st

which a particular opt

available for trading. r example, assume that on a give
three expiration dates and four strike prices are listed for trading.
endar day gives rise to twelve contract days. The contract-day
allows us to consider the exercise behavior in a given option as
defined not only bv its expiration, but also b rice. or example, in
row i of table 2,we observe that for the expiration, exercise
occured on 100 different contract days. For an option specified by both
iration and strike price, traders exercised the entire open interest on ei
those contract days and only a portion of the open interest on
remaining ?2 cant
g transaction costs, all traders face the same incentives to exercise.
three columns of table 2 show, however, that traders frequently
exercise only a fraction of the open interest for an option with a given
ration date and strike price, as just discussed for the ch 1985 expira-
This suggests that either those exercising or those fa to exercise err.
iscuss below, different transaction costs among traders could rational-
ize different exercise decisions in a given situation.

ying exercise behavior at expiration is important for two reasons. First,

e exercise condition is clearest at expiration, because it depends only upon

e failures to exercise, there are

Call exercise behavior at expiration for Treasury bonds futures option portraits maturing
1985-1986.

Failure to exercise Faulty exercise

--- __-___- --__~__
Futures Failures
Contract price Total Contract Total Avg. loss Total Contract Total Avg. loss
maturity proxy a number day sd $ loss per failure number daysd $ loss per error
__-__-
Mar. 85 SETTLE 0 0 $ 0 $ 0 6 1 $ 1.875
OPEN 0 0 0 0 6 1 1.1575
BEST 0 0 0 0 6 1 ,875
Jun. 85 SETTLE 102 1 191,250 1.875 15.973 1 1.997250
OPEN 742 2 1,085.125 1.462 0 0 0
BEST 102 1 191.250 1,875 0 0 0
Sep. 85 SETTLE 27 1 46.406 1.719 4 i 1.125
OPEN 27 1 42.1 f!8 1.563 4 1 1.750
BEST 27 1 42,188 1,563 4 1 1.125
Dec. 85 SEYI-LE 3 1 4,406 1,469 0 0 0
OPEN 1 5.719 1,906 0 0 0
BEST : 1 4,406 1,469 0 0 0
Mar. 86 SETTLE 15 2 10,813 72:1 0 0 i)
OPEN 15 2 14 534 940 0 0 0
BEST 1.j 2 ,0:813 721 0 0 0

Jun. 86 SETTLE 0 0 0 0 0 0 0
OPEN 0 0 0 0 0 0 0
BEST 0 0 0 0 0 0 0

Sep. 86 SETTLE 18 2 20.063 1.115 0 0 0

OPEN 18 2 18,375 1,021 0 0 0
BEST 18 2 18,375 1,021 0 0 0

Dec. 86 SETTLE 3,986 1 622,615 156 0 0 0

OPEN 3,986 1 622,615 156 0 0 0
BEST 3,986 1 622,615 156 0 0 0

All SETTLE 4,151 8 $ 895,553 $ 216

15,988 3 $2.OOO.250
4,791 9 1,788,313 373 1 3.625
contracts OPEN 10 L
8 889,844 214 t 3.000
BEST 4,151 10 ,_
-- ---~ __- __-.____--- .-_
SETTLE refers to anafyzing exercise behavior based on the 2:OO p m. future!, scttlemcnt price:
refers to analyzing exercise behavior based on the next trading days ofcning fr.tturcs price: and BES
to analyzing exercise behavior based on the most favorble of the twc prices for the hv
exercise.
bAt expiration, faifure to exercise refsrs to not exerclsi
At expiration, faulty exercise refers to exercising an ou
s defined as a day on which a particula
 Table 3b
Put exercise behavior at expiration for Treasury bond futures option contracts maturing during
1985- 1986.
----__ __..____ -.____ _
Failure to exercist? Faulty exercise
--___ - -.___ __._ ___ --_ ___---
Failures Errors
Futures -.--__ -~
Contiact price Total Contract Total Avg. loss Total Contract Total Avg. loss
maturity proxy number days $ loss per failure number daysd $ loss per error
---___ __~_____-___-~~ -.-_____ _______
ar. 85 SETTLE 74 1 $ 23,125 $ 313 0 0 $ 0 $ 0
OPEN 74 1 2 3,125 313 0 0 0 0
BEST 74 1 23,125 313 0 0 0 0

Jun. 85 SETTLE 2.860 1 357.500 125 0 0 0 0

OPEN 0 0 0 0 88 1 104.500 1.188
BEST 0 0 ,O 0 0 0 0 0
Sep. 85 0 0 0 0 0 0 0
OPEN 0 0 0 0 0 0 0
BEST 0 0 0 0 0 0 0
Dec. 85 SET-I L>E 0 0 0 0 0 0
OPEN 0 0 0 0 0 s)
BEST 0 0 0 0 0 0
Mar. 86 SETTLE 0 0 0 5 1 93x 18X
OPEN 0 0 0 5 1 2.(31 406
BEST 0 0 0 5 1 938 188
Jun. 86 SETTLE 61 1 64,813 1,063 0 0 0 0
OPEN 61 1 38,125 625 0 0 0 0
BEST 61 1 38,125 625 0 0 0 0
Sep. X6 SETTLE 1 1.219 1.219 0 0 0 0
OPEN 1 1,313 1,313 0 0 0 0
BEST 1 1.219 1.219 0 0 0 0
cc. 86 SETTLF 0 0 0 0 22 1 3.438 156
OPEN 0 0 0 0 22 1 3.4313 156
BEST 0 0 0 0 22 1 3,438 156
All SETTLSE 2,996 4 $446,657 $ 149 27 2 $ 4.375 $162
contracts EN 136 3 62,563 460 115 3 109.969 956
ST 136 3 62,469 459 27 2 4,375 162
~___ -_---______~- ___--.---
alyzing exercise behavior based on the 2:00 p.m. futures settlement price:
I-S to analyzing exercise behavior based on the next trading days opening futures price: and
refers to analyzing exercise behavior based on the most favorable of the two prices for the
esis of rational exercise.
0 exercise refers to not cxcrcistng an In-thc-moncy contract.
ise refers to exercising an out-of-the-moncv contract.
as a day on which 2 particular option of a given expiration and cxcrciw
 serve announced a cut in the discount rate.

these market participants, ho

rate.
Exercising an option is costly, and a rational e ecision must be
profitable after exercise costs are taken into account.
costs might explaLt an apparently irrational failure to exercise.
cost: vary widely among market participants.
marginal cost of exercising a contract
exceeds $1.00. Fos a trader off the floor,
and may reach as much as $100 per cont.
rationality of an exercise decision d
trader faces. Since no data identif
traders, we can mak:; only general i
exercise decisions. For an option at expiration, it is very
rationality of a failure to exercise

ovi
 Table 4
Distribution of all call and put exercise losses at expiration based on diKerent futures price proxies for all Treasury bond futures option contracts maturing
during 1985-1986.
.-- _._____ _ --___ --- -_ ..____._________ _ -... ---- - --_-___ --__--
Calls Puts
______ -__ --__ -.- -----_-_. --- ---- ____-____.--
Futures Fake to exercise Faulty exercise Failure to cxcrcisc Faulty cxercisc
___- --._____ _--.-- - __.______ --~- -_-_ _-_ --- ------ --------_
pnce Loss per Loss per Loss per Loss per
proxy failure Number Percent error Numtcr Pcrccnr lailurc Number Pcrccnr error Number Percen 1
--___ - _-_ -- - -___ ~_._________ ---- -- -._ ______-__-_-~---~-- -_____-.- ---_---_
SETTLE $ 156.25 3,986 96.03 $125.00 15.978 99.94 $ 125.01) 2,860 95.46 $156.25 81.4X
187.50 11 0.26 281.25 4 0.02 312.50 74 2.47 187.50 18.52
781.25 17 0.41 312.50 6 0.04 1.062.50 61 2.04
1.468.75 3 0.07 1.218.75 1 0.03
I .718.75 27 0.65
1.875.00 102 2.46
2.187.50 4 0.10
6.781.25 1 0.02
4.151 100.00 15.988 100.00 2,996 100.00 100.00
---_ -- --- ----_- - -___. ---I__ - --_
OPEN ! 156.25 3.986 83.20 $312.50 6 60.00 $ 312.50 74 54.41 $156.25 19.13
406.25 11 0.23 437.50 4 40.00 625.00 61 44.85 406.25 4.35
687.50 17 0.35 1312.50 1 0.74 1.1x7.50 76.52
1.187.50 640 13.36
I .562.50 27 0.56
1.906.25 3 0.06
2.406.25 4 0.08
3.187.50 102 2.13
6.687.50 1 0.02
4.791 100.00 Ki 100.00 136 100.00
__ -- _----_
?IEST $ 156.25 3.986 96.03 $281.25 4 40.00 $ 312.50 74 5441 $156.25
187.50 11 0.26 312.50 6 60.00 625.00 61 44.x5 187.50
687.50 17 0.41 1.21x.75 1 0.74
1.468.75 3 0.07
1.562.50 27 0.65
1.875.50 102 2.46
2.187.50 4 0.10
6.687 50 1 0.02
4,151 100.00 i-0 100.00 136 ioo.00
.._ - ---- ----- --_ _-_-- _~_______ - ---.__-__- ___-. _________ _~---- ---- - _-
SETTLE refers to analyzing exercise behavior based on the 2:00 p.m. futures settlement price; OPEN refers to analyzing exercise behavior based on the next trading days opemng futures
price: and BFST refers IO analyzing exercise behavior based on the most favorable of the two prices, for the hypothesis of rational exercise.
hAt expiration, failure to exercise refers to not exercising an in-the-money contract.
At expiration. faulty exercise refers to exercising an out-of-the-money contract.
 G. Gay ct al., Rationality in the exercise of futures options 353

$156.25 per contract: and at times the loss amounted to several thousand
dollars per contract. Although not quite as large or frequent, the losses from
failure to exercise puts were comparable. These losses appear to be too large to
justify by transaction costs alone. C?n the other hand, the losses reported for
faulty exercise of both puts and calls are in addition to the costs traders
incurred to initiate their exercises.

4.2. Exercise behavior before expiratioro

Before expiration, the rationality of an exercise depends on the relationship
between the equilibrium futures price and the critical futures price discussed in
section 2. Thus, any test of exercise behavior before expiration jointly tests the
rationality of exercise behavior and the accuracy of the futures option pricing
model. To measure the accuracy of the model, we examine the relationship
between the market and model prices of the futures options. For all 10,473 call
observations, the model price exceeds the market price by an average of $5.40
per $100,000 contract, and for the 10,605 puts the model price exceeds the
market price by an average of $30.70 per contract! In a study of bid-ask
spreads, Jordan and Seale (1985) interview traders who report that near- or
at-the-money Treasury bond futures options have normal bid-ask spreads of
1/64th to 1/32nd, or $15.63 to $31.25 per contract, and that deep iii- or
out-of-the-money options may have bid-ask spreads of 4=5/64ths, or $62.50
to $78.13 per contract. Their empirical analysis largely confirms these reported
spreads, except that bid-ask spreads on out-of-the-money options rarely
exceed 1/64th. The model appears to be robust, as the observed pricing errors
appear to be minor, especially when compared with reported bid- -ask spreads.
(A table presenting these results is available from the authors on request.)
In computing critical futures prices to determine whether traders make
exercise errors, *weuse the implied standard deviation (ISD) from the same
days trading, since most exercises occur late in the evening and traders have
access to information contained in the current days prices. Also, we use the
nearest-to-the-money option for an important, though subtle reason. Gener-
ally, this option has the greatest volume and thus suffers least from nonsyn-
chroneity with the other parameters of the model. More importantly, recall
that we are interested in estimating the critical future: price, F*, which in turn
is a function of volatility. When the option, prior to expiration, is a candidate
to be exercised, its price will equal the exercisable proceeds F - X. As a result,

These deviations compare quite favorably with those reported in Whaley (1986) who applies
the model to the valuation of options on the S&P 500 futures contract. Whaley reports average
deviations of - $30.30 for calls and $26.85 for puts for a large sample of observations taken
during 1983, a period when the S&P 500 futures contract had an approximate delivery obligation
value of $100,000~ which is fairly comparable to that of the T-bond futures contracts analyzed
here.
 G. Guy et al., Rationah& in the exercise of futures optiom

t have been exerci

od of counting errors, eat

e base the loss computations on the

time, but only a small average loss per failure.

illion to 1.8 million, with an z Jerage loss per error of about $1.56. This result

an unfavorable situation in which a holder of a call

are somewhat negligent in the surveillance of their open

T results always equal the SE LE or OPEN results. This is not

on each contract maturity and

-0ntracts life, however,

Mar. 85 SETTLE 36,034 259 $ 42,925 $ i.19 2.163 21
OPEN 35,452 260 42,677 1.20 2,162 20 6.92
BEST 34,785 254 41,529 1.19 2.;62 20 6.82
Jun. 115 SETTLE 150.013 77 116.752 0.78 ,484 13 9.302 6 27
OPEN 139,010 79 114.021 0.82 3.308 13 9.571 z 89
BEST 136,687 76 111.500 0.82 1.376 BZ 7.202
Sept. 85 SETTLE 122,433 210 178,148 1.46 4,086 31 87,560
QPEN 140.187 213 186,255 1.33 7.491 31 90,576 12.09
BEST 114,522 204 165.51; 1.45 2,969 29 61,209 X.62
Dec. 85 SETTLE 181,769 131 165,383 0.91 14,024 23 86.181 6.15
OPEN 161,373 128 157.017 0.97 14,377 23 76.17? 5.30
BEST 159,652 126 154.807 0.97 13.907 22 64.353 4.63
Mar. 116 SETTLE 593,908 212 793.140 i-34 5,846 34 41,840 7.16
-.
OPEN 626,594 212 816,629 1.30 10,113 51.061 5.05
BEST 571,249 208 764,630 i.34 5.213 ;; 32.790 6.29
Jun. 86 SETTLE 432,127 470 1.083.999 2.51 22.904 74 264,525 11.55
OPEN 482,691 478 1.190.199 2.47 14.745 68 230.360 15.62
BEST 404,853 461 1,033.831 2.55 13,701 62 174,800 12.76
Sep. 86 SETTLE 210,688 322 322,348 1.53 8,061 47 218.341 27.09
OPEN 222.217 323 331,999 1.49 6,173 44 170,203 27.57
BEST 200,188 311 298.046 ! .49 6,172 43 25.19

Dec. 86 SETTLE 34,324 78 36,879 1.07 1,105 9 6.49? 5.88

OPEN 29.63 1 79 33.931 1.15 1,260 9 7,998 6.35
BEST 27,616 70 30,405 1.10 1,009 7 5.946 5.89

All SETTLE 1.7619296 1759 2.7399574 1.56 : 3,673 252 ?36,282 12.34
contracts OPEN 1,837,155 1772 2,872,728 1.56 59,629 244 650,892 10.92
BEST 1.649552 1710 Z6GO.260 1.58 46,509 228 516,524 11.11

ypotkesis of rational

ava_ir?lab~e
for trading.
 356 Gay et d Qdmalitv in the exercise of futures options

Table Sb
Put exercise behavior prior to expiration for Treasury bond futures option contracts maturing
during 11985-1986.

Failure to exercise Faulty exercise

Failures Errors
Fl_l!w?E
Contract price Total Contract Total Avg. loss Total Contract Total Avg. loss
maturity proxy a number daysd $ loss per failure number day& $ loss per error

Mar. 85 SETTLE 5,234 13 $ 3,284 $0.63 63 4 $ 576 9.14

OPEN 1,636 11 1,535 0.94 6: 5 498 7.43
BEST 1,636 11 1.535 0.94 5: 4 493 7.83
lr.. _ nr SETTLE 32 77 1.40 20: 4 781 3.85
JUiI. 03 55
fiPFN
V-U 2!? 33 165 0.76 173 2 835 4.83
BEST 51 28 71 139 173 2 711 4.11
Sep. 85 SETTLE 3.319 25 2,822 0.85 388 PO 3,207 8.27
OPE1c 3,187 25 2,661 0.83 474 10 2,232 4.71
BEST 2,549 24 2,289 0.90 382 9 2,216 5.80
Dec. 85 SETTLE 552 15 369 0.67 43 3 750 17.44
OPEN 552 15 368 0.67 43 592 13.77
BEST 548 14 364 0.66 43 : 592 13.77
Mar. 86 SETTLE 1,006 30 1,288 1.28 6 2 6,727 1.121.17
OPEN 1,453 32 1,753 1.21 462 3 7,371 15.95
BEST 459 27 580 1.26 6 2 6,727 1.121.17
Jun. 86 SETTLE 9,653 9 9,750 1.01 2.552 6 1,360 0.53
OPEN 30,093 13 25,413 0.84 71 3 111 1.56
BEST 9,653 9 9,750 1.01 71 3 63 0.89
Sep. 86 SETTLE 1,410 5 312 0.22 384 1 5,525 14.39
OPEN 3,347 8 2,346 0.70 384 1 4,954 s2.90
BEST 1.410 5 310 0.22 384 1 4,954 ?2.90
Dec. 86 SETTLE 18,795 12 11,559 0.62 497 4 83 0.17
OPEN 22.839 14 14,697 0.64 13 27 2.08
BEST I x:195 12 11,559 0.62 13 : 22 1.69
All SETTLE JO.024 141 29,459 0.74 4,136 34 19,009 4.60
contracts OPEN 63,324 151 48,938 0.77 1,687 30 16,620 9.85
BEST 35.101 130 26,458 0.75 2,135 27 15,778 13.90

SETTLE refers to analyzing exercise behavior based on the 230 p.m. futures settlement price: OPEN refers
to analyzing exercise behavior based on the next trading days opening futures price: and BEST refers to
analyzing exercise behavior based on the most favorable of the tvo prices for the hypothesis of rational
ex;rcise.
At expiration, failure to exercise refers to not exercising an m-the-money contract.
:At expiration. fault! exercise refers to exercising an out-of-the-money contract
A contract day is defined as a day on which a particular option of a given expiration and exercise price is
 ea a

r error ra

to exercise and exacerbates th

erefore, exercising calls that should not be exercise

he results for the puts

are low on average

of errors falls between 35,101 and 63,324, with a co

loss in the range of $26,326 to $48,93
exercise in the range of $0.74 to $0.77. n puts are exercise
which happens much less frequently, the a
the total dollar losses range from
ts and calls failures to exercise be
but cost little. y contrast, faulty exercises occur infrequently, but cost more:
Despite these losses, it is apparent that traders behave highly rationally in
their exercise decisions and that they make substantial use of information
arriving after the markets close to guide their exercise decisions.
Tables 6a and 6b provide more detail about the character of the exercise
errors before expiration an suggest that the exercise errors are not

exercise error is made. For the call results shown in table 6a, about one--thir

there are any questions about the reasonableness

 Table 6a
Distribution of futures price deviations from critical futures price for incorrect call exercise behavior prior to expiration for Treasury bond futures
options maturing during 1985-1986.
-- - _P
SETTLE OPEN BEST 9
Failure to exercise Faulty exercised Failure to exercise Faulty exercise Failure to exercise Faulty exercise $
--
Deviation Number % Number % a
Number % Number % Number 5%- Number %
2
0.00 < Q L 0.01 595,491 32.41 35,843 60.07 604,962 34.35 38,280 - - 64.20 568,856 34.49 28,037 60.28 u-
0.01 < D _<0.02 459,315 25.00 16,729 28.03 416,344 23.64 13$1O 23.33 3 84,458 23.31 12,520 26.92 5
2
0.02 -C D 5 0.03 258,598 14.08 5,942 9.96 235,358 13.36 5,981 10.03 213,832 12.96 5,059 10.88 g
0.03 < D I 0.04 146,682 7.98 486 0.82 142,391 8.08 743 1.25 134,402 8.15 233 0.50
0.04, < D I 0.05 59,557 3.24 116 0.19 80,514 4.57 7186 0.31 64,297 3.90 132 0.28 z
0.05 -= D I O,Q6 124,283 6.77 307 0.51 101,212 5.75 375 0.63 113,581 6.88 384 0.83 ;
0.06 c D 5 0.07 51,712 2.82 227 0.38 41,204 2.33 19 0.03 37,088 2.25 120 0.26 a
0.07 c D < 0.08 29,889 1.63 17 0.03 37,972 2.16 .L14 0.19 39,470 2.39 17 0.04 2
0.08 < D _<0.09 32,552 1.77 0 0.00 23,874 1.36 14 0.02 22,625 1.37 0 0.00 2
0.09 < D I 0.10 24,912 2.36 0 0.00 21,841 1.24 2 0.00 18,606 1.13 2 0.00 $$
B > 0.10 54,164 2.94 7 0.01 55,624 3.16 5 0.01 52,337 3.17 5 0.01 q
--
Totals 1,837,155 100.00 59,673 100.00 1,761,296 IGXIW- 59,629 lUO.00 1.649.552 100.00 46,509 100.00 3
-.
SETTLE refers to analyzing exercise behavior based on the 2:OOp.m. futures settlement price; OPEN refers to analyzing exercise behavior based on 5
the next trading days opening futures price; and BEST refers to analyzing exercise behavior based on the most favorable of the two pieces for the 5-.
hypothesis of rational exercise.
$
bDcviation (B) equal to 1(F - F*) 1/P where F is the relevant futures price (see footnote a) and F* is the critical tail futures price, the price at
which the call owner is indifferent between holding and exercising the call.
Prior to expiration, failure to exercise refers to not exercising when the futures price is above the critical futures price.
dPrior to expiration, faulty exercise refers to exercising when the futures price is below the critical futures price.
 Table 6b
Distribution of futures price deviations from critical futures price for incorrect put exercise behavior prior to expiration for Treasury bond futures
options maturing during 1985-1986.

SETTLE OPEN BEST

Failure to exercise Faulty exercised Failure to exercise Faulty exercise Failure ta exercise Faulty exercise
Deviatior# -Number % Number % Number % Number % Number % Number !%

0.00 < D I 0.01 22,286 55.68 3,696 89.36 41 351 65.30 1,237 73.32 17,568 50.05 695 61.23
0.01 < D 5 0.02 12,325 30.79 425 10.28 12,022 18.99 435 25.78 12,189 34.73 425 37.44
0.02 < D < 0.03 3,673 9.18 6 0.15 8,181 12.92 6 0.36 3,604 10.27 6 0.53
0.03 < k!I5 0.04 1,690 4.22 3 0.07 258 0.40 5 0.30 1,690 4.81 6 0.53
0.04 < D ,< 0.05 50 0.13 0 0.00 0 0.00 0 0.00 50 0.14 0 0.00
0.05 < D s 0.06 0 0.00 3 0.07 1,462 2.31 1 0.06 0 0.00 0 0.00
0.06 < D _<0.07 0 0.00 0 0.00 50 0.08 1 0.06 0 0.00 1 0.09
0.07 < D s 0.08 0 0.00 1 0.02 0 0.00 0 0.00 0 0.00 0 0.00
0.08 < D I 0.09 0 0.00 0 0.00 0 0.00 0 0.00 0 0.00 0 0.00
0.09 < D I 0.10 0 0.00 0 0.00 0 0.00 0 0.00 0 0.00 0 0.00
D > 0.10 0 0.00 2 0.05 0 0.00 2 0.12 0 0.00
-_- 2 .- 0.18
Totals 40,024 loo.00 4,136 100.00 63,324 100.00 1,687 100.00 35,101 lOO.00 1,135 100.00

SETTLE refers to analyzing exercise behavior based on the 2:00p.m. futures settlement price; OPEN refers to analyzing exercise behavior based on
the next trading days opening futures price; and BEST refers to analyzing exercise behavior based on the most favorable of the two prices for the
hypothesis of rational exercise.
Deviation ( D) equal to I( F - P*) 1/P* where F is the rekv,ant futures pdce (see footnote aj and i=* is the criticaf put futures price, the price at
which the put owner is indifferent between holding and exercising the put.
Prior to expiration, failure to exercise refers to not exercising when the futures price is below the critical futures price.
dPrior to expiration, faulty exercise refers to exercising when the futures price is above the critical futures price.
360 G. Guy ePal., Ratioroali[~~
ill the exercise of futures optiom

s on the accuracy of the model

onetheless, considerng puts and

traders $532,302 in addition to the costs of exercising. Assessing failure to

ior to expiration depends a model of the critical fbltures price
ers transaction costs. efor,- expiratiorl we find 1.7 million
failures to exercise puts an. calls that cost traders $2.6 million; however, we
nowledge of transaction costs might modify these
ta &ciiiOt skvv an examination of ?his issue, we
enced traders incur much of this loss.
11 exercise khavior appears broadly consistent with
tion to their positions and exercising appropri-
artures from optimal exercise behavior, however,
auhy exercise and failure to exercise, both at and prior to
ow considerable ability to use information arriv-
to guide their exercise decisions.

cient analytic approximation or American option

options, Journal of Financial

6. 3