Smooth pasting as rate of return equalization

Sodal, S and Shackleton, M B (2005) Smooth pasting as rate of return equalization. Working Paper. The Department of Accounting and Finance, Lancaster University.

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Abstract

We further elucidate the smooth pasting condition behind optimal early exercise of options. It is easy to show that smooth pasting implies rate of return equalization between the option and the levered position that results from exercise. This yields new economic insights into the optimal early exercise condition that the option holder faces