Graduation Year

2026

Date of Submission

4-2026

Document Type

Campus Only Senior Thesis

Degree Name

Bachelor of Arts

Department

Economics

Reader 1

Eric Hughson

Abstract

While theory establishes clear guidelines for optimal exercise timing of American call options, empirical evidence documents widespread failure to exercise ahead of dividend payments even when optimal. Covered call writers naturally benefit from this behavior as they retain the entitlement to the dividend payment while the short call position also loses value. To quantify the effect of suboptimal exercise behavior, we take a covered call portfolio and test its performance in a setting where all investors follow the same strict exercise guidelines. We construct a counterfactual portfolio by identifying contracts where exercise was optimal but did not occur, and simulating an exercise. We compare the effects of two optimality conditions: exercise is optimal if the dividend is greater than the time value, and if the dividend minus transaction costs exceeds the time value. We test whether eliminating suboptimal exercise behavior creates abnormal returns over the observed portfolio. Under the transaction cost adjusted rule, the two portfolios are nearly indistinguishable across the whole sample, only deviating slightly in returns. The portfolio under the more naive signal, which disregards transaction costs, produces abnormal returns relative to the observed portfolio in the subperiod covering the first half of the sample, suggesting the transaction cost adjustment to the signal is a more realistic characterization of exercise behavior. Across the full sample, we find no statistically significant abnormal return, though we note that limited statistical power prevents us from ruling out an economically meaningful effect.

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This thesis is restricted to the Claremont Colleges current faculty, students, and staff.

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