Taxation and the Early Exercise of Call Options

Abstract

Prior studies of call option early exercise either ignore personal taxes or simplify the impact of taxation. When making an early exercise decision, the option holder should compare the after-tax cash flows from exercise with the after-tax cash flows from selling the option. Due to the differential taxation of option and share transactions, it is possible for exercise to be wealth-maximizing after tax even when it would not be the rational decision on a before-tax basis. By incorporating personal taxes on the option, underlying share and dividend this paper shows that tax can potentially explain a large portion of early exercise events classified as 'irrational' in previous studies. Copyright (c) 2010 Blackwell Publishing Ltd.