Market microstructure effects on the direct measurement of the early exercise premium in exchange-listed options

The Chicago Board Options Exchange concurrently listed European-style and American-style options on the Standard and Poor?s 500 Index from April 2, 1986 through June 20, 1986. We match near-the-money American option quotes with the most nearly contemporaneous, otherwise identical, European option quote. In this unique sample, the bid-ask spread for the American options is twice as large as the bid-ask spread for the European options. We find that the differences in the size of the bid-ask spreads and non-contemporaneous observations create an errors-in-variables problem that, if ignored, contaminates direct measures of the early exercise premium for American options. Our findings call into question other empirical measures of the early exercise premium that do not take into account these microstructure effects. We illustrate our errors-in-variable interpretation with a simulation of regressing American trades on European trades.