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OPTION VALUATION AND DIVIDEND PAYMENTS

When a company pays dividends, option valuation requires careful attention to the
particulars of those payments. This note discusses how dividend payments affect option values
and some approaches to handling those effects in valuation models. Valuation effects flow
directly from the effects of dividend payments on share price and resulting investor behavior.
First, lets consider some key features of dividend payments themselves.

Dividend Payments
Cash dividends are payments from the firm to shareholders. When a dividend payment is
announced, the firm also provides information on two important events. The first is the holderof-record date. The list of shareholders on that date receives the dividend. The other date is the
payment date. The dividend will actually be paid on that date. The exchange on which a stock is
traded also sets something known as the ex-date or ex-dividend date. The ex-date is the date on
which purchasers of the stock do not receive the upcoming dividend. For the New York Stock
Exchange (NYSE), the ex-date is set by Rule 235:
NYSE Rule 235. Ex-Dividend, Ex-Rights: Transactions in stocks (except those
made for cash) shall be ex-dividend or ex-rights on the second business day
preceding the record date fixed by the corporation or the date of the closing of
transfer books. Should such record date or such closing of transfer books occur
upon a day other than a business day, this Rule shall apply for the third preceding
business day.
On the NYSE, individuals who buy the stock two business days before the holder-of-record date
do not receive the dividend. For example, suppose ABC, an NYSE-listed company, announces a
dividend of $1.00 a share and the holder-of-record date is September 28, 2006 (a Thursday) and
the payment date is October 19, 2006. Here, the ex-date would be Tuesday, September 26, 2006.
Individuals who purchase the stock on or after that date would not be entitled to the $1.00
dividend to be paid on October 19. Because a purchaser on Monday, September 25, would get
the dividend and a purchaser on September 26 would not get the dividend, all things being equal,

This note was prepared by Professors Robert Conroy and Robert Harris. It was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2007 by the
University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an
e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.

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we would expect the stock price to drop by $1.00 between September 25 and September 26. This
stock-price drop1 is what complicates option valuation.

Dividend Payments and Options

Option prices depend on the current market value of the underlying asset. In the case of
options on stocks, the underlying asset is the stock price, which is affected by dividend
payments. In turn, the option value is also affected by dividend payments. We first consider how
dividends affect the valuation of call options.
European call options: Known-dividend approach
The simplest case is a European call option where there are specific ex-dividend dates
prior to the options maturity. Consider a European Call option on one share of XYZ stock with a
maturity time of five months and a strike price of $25. The stock is trading at $26 a share, and
the company has announced a quarterly dividend of $.60 with an ex-date in three months. After
the announcement, we know the upcoming dividend is to be paid. But because the option is
European and can only be exercised after the ex-date, we have an option on the stock without the
$0.60 dividend. The underlying asset is the stock but without the right to receive the dividend.
Note that we focus on the ex-date because this is when the stock price drops. If the options
maturity goes beyond the ex-date, we need to adjust for the dividend payment.
To adapt the Black-Scholes model for this known dividend payment, we redefine the
underlying asset value (UAV) to be the value of the stock without the dividend, or UAV =
Current stock price Present value of the dividend payment, which will not be received by the
option holder.
We take the present value of the dividend payment, discounting it back from the payment
date to the present, where tD is the dividend-payment date.2 Because it is usually easier to find
information on ex-dates than on actual payment dates, practitioners often use the ex-date as an
approximation of the payment date, given that the two dates are typically so close together.

Technically speaking, we would expect the price decline on the ex-date to be equal to the present value of the
dividend payment. For instance, in the text example, the ex-date is about three weeks prior to the actual payment
date (September 26 vs. October 19), so the expected price drop would be less than $1.00 (by the time value of
money for the three weeks). Because this time period is so short, we approximate the ex-date price decline as just
the value of the dividend.
2
Note that the dividend-payment date, tD, and the maturity date, T, of the call option are different. Also note
that whether we need to do the dividend adjustment at all depends on whether the ex-date falls prior to the options
maturity because the ex-date is when the dividend affects the stock price. For instance, if a European call option
matured in 30 days, the ex-date was in 20 days, and the payment date was in 43 days, we would still have to adjust
todays option valuation for the dividend payment.

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-3Assuming a risk-free rate of 5% (continuously compounded), the UAV is

UAV = S 0 Dividend e

R f tD

= $26 0.60 e

.05 3
12

= $25.407

Assuming a volatility of .25, the Black-Scholes value of this European call can be calculated as
follows:
UAV
X
T
Rf

=
=
=
=
=

R tD

S 0 Dividend e f = $26 0.60 e

$25
.4167 years (5 months)
5%
.25 (assumed)

.05 3
12

= $25.407

Black-Scholes call value = $2.107, adjusted for known dividend

As a comparison, suppose we had ignored the dividend and used an underlying asset value of
$26.00. The resulting Black-Scholes value of the call would have been $2.492. The drop in the
calls value from $2.492 to $2.107 (adjusted for the dividend payment) is because the call owner
will not capture the upcoming dividend payment.
In summary, when there are known dividend payments, we value European call options
by calculating a new underlying asset value. This is done by taking the stock price and then
subtracting the present value of the dividend that we will not receive while holding the option. If
there is more than one dividend ex-date prior to the call options maturity, we would subtract the
present values of all those dividend payments. We then use the adjusted UAV in the BlackScholes formula to value the call.
European call options: Constant-dividend-yield approach
Another way to account for dividends is to assume that dividends are paid out
continuously at a certain dividend yield rate. This is an abstraction, but a useful one, if we are
looking at a relatively long time period that may include a whole set of dividend payments by a
firm. This assumption allows us to effectively subtract the present value of a flow of dividends
from the share price to get at the true underlying asset value for the option holder.
Dividend yield is typically expressed as the annual dividend as a percentage of the stock
price. Hence, in the example used above, the dividend yield3 for XYZ stock would be
Dividend yield = dy =

Annual Dividend
2.40
=
= 9.23% .
Stock Pr ice
26.00

A quarterly dividend of $0.60 translates to an annual dividend of $2.40.

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To take out the dividend flow that the option holder will not receive, we calculate the
underlying asset value as follows:
UAV = Current stock price discounted at the dividend yield rate, or
UAV = S 0 e dyT ,
where S0 is the current stock price, dy is the appropriate dividend yield, and T is the time to
maturity of the option. The calculation reduces the stock price by the dividend rate.4 Using the
example from above, lets look at an option with a maturity of five years and a strike price of
$25. Assuming that the dividend yield is 9.23%, the UAV would be

UAV = S 0 e dyT = $26 e .09235 = $16.389 .

This UAV of $16.389 means that expected dividends over the next five years account for about
$10 of the current share price of $26. To be precise, the five years of dividends are worth $9.611
(i.e., 26 16.389 = 9.611). Because the option owner of a European call will not capture these
dividends, the owner effectively has an option on a non-dividend-paying stock that is worth
$16.389. The value of the option would be as follows:
UAV
X
T
Rf

=
=
=
=
=

S 0 e dyT = $26 e .09235 = $16.389

$25
5.0 years
5%
.25 (assumed)

Black-Scholes call value = $2.587

Typically, we use the known-dividend approach for shorter maturities and the constant-dividendyield approach for longer maturities.
American call options: No dividend payments

Unlike European call options, American calls can be exercised at any time up to and
including the maturity date. The possibility of early exercise complicates valuation because, as
we will discuss shortly, it sometimes makes sense to exercise early in order to capture a dividend
payment. As it turns out, the only time we can directly value an American options value using
4

At first glance, a calculation that discounts at the dividend yield rate (i.e., e-dyT) may not appear logical. In fact,
the calculation works because it is a shorthand way of accomplishing another calculation. The return on a stock (r) is
the sum of dividend yield (at rate dy) and capital gains (say, at rate g). But the European call owner doesnt get the
dy part of the return because of dividends; the return on his underlying asset is only g. When the underlying stock
price grows at g and we discount this at r using continuous compounding, we can use the rules of exponents to do
the calculations by taking the current share price to the power of (gr). But because r = (dy + g), (gr) is just equal
to dy. That is the result we have above: we discount the current share price at dy (taking it to the dy power).

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the Black-Scholes model is when there are no dividend payments. This is because there will be
no reason for the American call to be exercised early. So if there are no ex-dividend dates prior
to the maturity of the American call, we can just pretend that we have a European option and use
Black-Scholes to value an American call.
The intuition for this result is easiest to see for a non-dividend-paying stock. So long as
we can buy and sell the American call in the market, we would never choose to exercise early. If
we exercise early, we collect the intrinsic value (S X), but if we sell the option, we get the
intrinsic value plus the time value. Therefore, even if one thought the stock price was going to
drop, one would never exercise early; rather, one would sell the option in the market. In this
case, the values of the American call and the European call would be the same.
American call options: Dividends and early exercise

Valuation of American call options is different when we have dividend-paying stocks

because early exercise may occur. On the dividend ex-date, the price of the stock drops by the
amount of the dividend. Knowing this, the holder of a call option must decide on one of two
strategies just before the ex-date. The holder can exercise now (early exercise) and capture the
current intrinsic value of the call or wait and take the reduced intrinsic value (stock price drops
by the amount of the dividend) but keep the time value.
To illustrate the decision, consider an American call option with a maturity of seven
months and a strike price of $40. The current share price is $41, the volatility is .20, and the riskfree rate is 5%. There is a dividend of $.75 with an ex-date in four months. If the day before the
ex-date the stock price is $43, the option holder must decide whether to exercise the option early
and collect $3.00 (the intrinsic value of S X: $43.00 $40.00 = $3.00) or not exercise early and
have a call option on a stock with a price of $42.25 (S dividend5) and a remaining time to
maturity of three months. The value of this call would be as follows:
UAV
X
T
Rf

=
=
=
=
=

$42.25
$40
.25 years (3 months)
5%
.20 (assumed)

Black-Scholes call value = $3.358

Call value
$3.358

=
=

Intrinsic value +
$2.25
+

Time value
$1.108

The value of the call is $3.358. Because it is greater than the $3.00 from early exercising, the
holder will not exercise early. The driver of the decision not to exercise is the fact that the time
5

Note that because the ex-date occurs essentially immediately, the dividend is already a present value and we
are applying the European known-dividend-payment approach discussed earlier.

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value of the option ($1.108) more than offsets the reduction in the intrinsic value (from $3.00 to
$2.25) when the stock goes ex-dividend.
In other circumstances, however, early exercise will make sense. If just before the ex-date
the stock price is $50, the value to exercise early is $10.00 (capturing the intrinsic value of $10 =
$50 $40). The value of the option with the remaining three months to maturity would only be
$9.768.6 Because the value of early exercise is greater, the holder would choose to exercise early.
By trying different stock prices, we can determine that if just before the ex-date the share
price is $45.13, then the value of early exercising would be $5.13 and the value of the option
would be $5.13. Because the two values are the same, the holder would be indifferent7 between
exercising early or not. Thus, we can see that if just before the ex-date the stock price is above
$45.13, then the holder will exercise early. If the price is below $45.13, then the holder will not
exercise early.
American call options: Valuing American call options on dividend-paying stocks

Fortunately, we can still get an approximation of the American calls value if we use the
Black-Scholes model in a more complicated way. The basic approach described below uses
Black-Scholes to figure out the value of two European options. One of the options has the same
maturity as the American call. The other European calls maturity expires just prior to the exdate. These two options capture two strategies available to the American calls owner. The
longer-maturity option is what would happen if there were never any early exercise. The shortermaturity option captures what happens if there is always early exercise. The valuation insight is
that the American option is worth at least as much as the more valuable of the two European
options. This is because the American calls owner can pick either strategy. We calculate the
values of these never-exercise and always-exercise European calls. The American call is
worth at least as much as the larger of these two values.
To implement this approach, lets return to the situation where we have a stock with a
current price of $41, a dividend of $0.75 with an ex-date in four months, a volatility of .20, and a
risk-free rate of 5%. We want to value an American call option with an exercise price of $40 and
seven months to maturity.
We proceed by considering two specific European calls. The first has an exercise price of
$40 and a maturity of seven months. This is just a normal European call option, and it will have
6

UAV

= $49.25, X =

$40, T = .25 years (3 months), Rf = 5%, = .20 (assumed)

Black-Scholes call value = $9.768

Call value
$9.768
7

=
=

Intrinsic value
$9.25

+
+

Time value
$0.518

This indifference point is found through trial and error by finding the stock price just before the ex-date where
the early-exercise value is equal to the value of the call if the option is not exercised early.

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the same ultimate payoff as if we held the American call option until maturity. The second is a
European call option with an exercise price of $40 and a maturity of four months (just before the
ex-date of the dividend). This call option provides the same payoff as if we always exercised the
American call option early prior to the ex-date of the dividend.
European call: Hold to maturity, never exercise early
X = $40 & T = 7 months

UAV
X
T
Rf

R T

= S 0 Dividend e f = $41 0.75 e

= $40
= .583 years (7 months)
= 5%
= .20 (assumed)

.05 4

12

= $40.262

Black-Scholes call value = $3.178

European call: Always exercise early

X = $40 & T = 4 months
UAV = S0 = $41.00
X
= $40
T
= .333 years (4 months)
Rf
= 5%

= .20 (assumed)

Black-Scholes call value = $2.797

Because we can make either of these choices with the American call option, the American call
option must be worth at least as much as the more valuable of the two European calls. In this
case, we can say that the American call option with a maturity of seven months and an exercise
price of $40 is worth at least $3.178, the value of the seven-month European call, which, in turn,
is worth more than the four-month European call.
But if the dividend payment is large enough, the value of the shorter-maturity European
call can exceed the value of the longer-maturity European call. This is because a larger dividend
payment would lead to a larger stock-price drop on the ex-date and make holding the option to
maturity less likely. For example, if the dividend were $1.50 instead of $0.75, the value would be
as follows:

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-8European call: Never exercise early

X = $40 & T = 7 months

UAV
X
T
Rf

R T

= S 0 Dividend e f = $41 1.50 e

= $40
= .583 years (7 months)
= 5%
= .20 (assumed)

.05 4

12

= $39.525

Black-Scholes call value = $2.737

European call: Always exercise early

X = $40 & T = 4 months
UAV = S0 = $41.00
X
= $40
T
= .333 years (4 months)
Rf
= 5%

= .20 (assumed)

Black-Scholes call value = $2.797

So when the dividend is $1.50, the value of the American call option with a maturity of seven
months and an exercise price of $40 is at least $2.797, the value of the four-month European
option.
This approach of comparing two European calls to value an American call option is just
an approximation, but it turns out to work fairly well. More-complicated approaches to pricing
American calls are available that get even better value estimates. Nonetheless, this
always/never approach is a good approximation.
European put options

We can value European puts on dividend-paying stocks using a slightly modified

equation for put-call parity. With dividends, the put-call-parity relationship needs to be restated
to acknowledge different dividend flows to stock ownership and call ownership. In essence, the
stock owner captures some dividend payments that the call owner does not. For instance, if you
had a European call with a one-year maturity, you would not get any of the quarterly dividend
payments during the year. This would be reflected in a lower value for your call, as weve
discussed earlier. If you held the stock for the year, however, youd get the quarterly dividend
payments and still own the stock at the end of the year. To see how this affects put-call parity,
recall that put-call parity is based on picking a strategy of owning stocks and puts that leads to
exactly the same payoff at maturity as owning bonds and calls. In the presence of dividends, the

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extra wrinkle is that the strategy of owning stocks and puts also provides the dividend payments
during the life of the options (prior to maturity). Market forces will thus ensure that the stockplus-put strategy should be worth more than the bond-plus-call strategy by exactly the value of
the interim dividend payments. In equation form, we have
Stock + Put = Call + X e

R f T

+ De

R f t D

where Rf is the risk-free rate, X is the exercise price of the put and call, D is the dividend, and tD
is the time to the dividend payment. Hence, the value of a European put option is
Put = Call + X e

R f T

+ De

R f t D

Stock .

Note that the calls value in the above equation is the value of a European put adjusted for
dividends. For longer-term European puts, we can make a similar application of put-call parity if
we assume a flow of continuous dividend payments. We simply adjust put-call parity by adding
back the value of the flow of dividends over the life of the option.
American put options

Valuing American puts is more complex because incentives for early exercise differ
between puts and calls. In the case of call options, we saw that it often does not make sense to
exercise an American call early even in the presence of dividends. This is because the time value
of the call would be large enough to forestall early exercise. In the case of puts, however, early
exercise can make sense even if there are no dividends, and dividends just add to the complexity.
A good rule of thumb is that early exercise is typically not a large issue for out-of-the-money
puts. Their values can be approximated by assuming they are European. In contrast, deep-in-themoney puts tend to trade at or near their intrinsic value (early-exercise value, X S).
To see the forces at work with put options, lets recall what happens with calls. Earlier,
we discussed why a call holder would not exercise an American call prior to maturity. For such a
call, it was always better to sell the option in the market and capture the calls time value. Only
with dividend payments did we have to worry about early exercise of American calls, and even
then early exercise often did not make sense as doing so would give up the time value. For
American puts, incentives are different. Consider an extreme example: suppose the stock price of
a non-dividend-paying stock goes to zero and you own an American put. In this case, the put is at
its maximum value because the price can go no lower. The optimal strategy is to exercise early,
collect the difference between the exercise price and zero, and then invest in the risk-free asset
until the puts original maturity date. Waiting to exercise means you (and any other potential
buyer of the put) would forgo the time value of money without any chance of an offsetting
benefit. The American put would be exercised early and be worth more than a European put. In
general, for deep-in-the-money puts (X much greater than S), it can be optimal to exercise early
in order to collect the intrinsic value and invest at the risk-free rate for the remaining time to
maturity. In such cases, the American puts value can be approximated as the intrinsic value (X
S) from early exercise.

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Another way to see the incentives surrounding early exercise is to look at put-call parity.
From put-call parity (no dividends), we get the following:
Stock + Put = Call + X e
Put = Call + X e

R f T

R f T

Stock

It makes sense to exercise a put early only if the early-exercise value (X S) exceeds the value of
the put from put-call parity. This is because the put owner has the alternative to hold the put until
maturity, which would yield the same value as the European call (calculated from put-call
parity). In symbols, early exercise will make sense only if
X S > Put = Call + X e

X 1 e

R f T

R f T

) > Call .

The left-hand side of the inequality is essentially the present value of getting the exercise price
today (early exercise of the put) versus forgoing early exercise and waiting until maturity (T) to
get the exercise price. The right-hand side of the inequality is the value of the call. Early exercise
makes sense only when the calls value is relatively small. When will this occur? Call values are
very small precisely when they are far out of the money (S is much lower than X). But that is
exactly when puts are deep in the money. So early exercise most likely makes sense for deep-inthe-money puts.
Overall, valuing puts is more complicated than valuing options. In the case of European
puts, we can use put-call parity to value a put, taking advantage of having already valued the call.
We can also extend this approach to European puts on dividend-paying stocks, with appropriate
adjustments to put-call parity.
American puts, however, are even more complicated than American calls owing to
incentives surrounding early exercise. Even for stocks that dont pay dividends, it may make
sense to exercise an American put early. Prospective ex-dividend dates during the life of a put
actually reduce incentives for early exercise because stock prices decline on ex-dates. Remember
that put owners profit from lower prices. Understanding the issues surrounding early exercise
leads to some key valuation insights. If the probability of early exercise is very high, the
American put will tend to trade near its intrinsic value (the amount X S, which could be
realized upon immediate exercise). This situation best fits deep-in-the-money puts. If the
probability of early exercise is very low, the American puts value can be approximated by just
assuming that it is European. This situation best fits American puts that are way out of the
money.

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Summary

Whenever a stock pays dividends prior to an options maturity, valuing the option is more
complex. This is because the option owners underlying asset is effectively the stock minus the
value of the dividend payments. A similar insight applies to a host of options on other assets. For
instance, if an oil well is currently pumping and selling oil, the owner of a long-term European
call on that well does not capture the value of current production.
By making appropriate adjustments to the underlying asset value, we can still deploy
option-pricing models (e.g., the Black-Scholes model) to value European call options on
dividend-paying stocks. Valuing American calls is more complicated because such options may
be exercised prior to maturity in order to capture a dividend.
Valuing puts is more complex than valuing calls. In the case of European puts, we can
use put-call parity to value a put, taking advantage of having already valued the call. We can also
extend this approach to European puts on dividend-paying stocks, with appropriate adjustments
to put-call parity. American puts, however, are even more complicated than American calls
owing to incentives surrounding early exercise. By understanding the factors that influence
exercise decisions, we can glean practical insights into how to approximate the values of
American puts.