on traders are aware that M American-type option is generally worth more than 0 a European-type option because of the potential for exercise at any time until expiration of the contract. This difference may be termed the early exercise premium.
Only recently has it become possibie to empirically measure the value of this early exercise premium in the case of the foreign exchange market.
In September of 1985 the Chicago Board Options Exchange (CBOE) began trading in European-style foreign currency options in order to exploit a potential need by hedgers who have no early assignment risk for contracts that coincide with the maturity of futures. ' Virtually identical American-style options have been trading on the Philadelphia Stock Exchange (PHLX) since December of 1982. This permits, for the first time, a direct measurement of early exercise premium.
Empirical testing of the early exercise premium of foreign currency options is particularly interesting for a number of reasons. Most important is the significant crosssectional variation in foreign interest rates. As discussed later, the likelihood of early exercise is influenced by the relative values of domestic and foreign interest rates. The holder of foreign currency should actually be viewed as possessing a foreign bond paying a continuous coupon. A call option-holder may be induced to give up the time value of the option if there is the potential to earn sizeable inkrest on the proceeds of the foreign currency. Therefore, as the foreign interest rate increases relative to the domestic rate, the likelihood of early exercise and the value of the p m i u m increases for call options. The situation for puts is exactly reversed. By exercising early, the option-holder yields the foreign currency and replaces it with dollars. If the foreign interest rate is high, the attractiveness of early exercise is low. Since interest rates vary widely across currencies, This research was partly supported by a grant from the Center for the Study of Futures Markets at Columbia University. Research assistance was ably provided by Liang Chen. We thank Peter Bossaerts, Robert Connolly and two anonymous referees for helpful comments. Portions of this research were completed while the second author visited the faculties of Baruch College and UCLA.