Equity options l Cutting edge
Finessing fixed dividends
How should one account for fixed cash dividends in equity option pricing? As recently
discussed in these pages, there are a variety of possible approaches. Here, Michael Bos and
Stephen Vandermark present a variant of the stock price adjustment approximation that
closely matches numerical results
T
he incorporation of a dividend yield in Black-Scholes option valua-
tion is simple, as a yield does not interfere with the lognormal nature
of the underlying asset. It does not matter in this regard whether the
dividend yield is paid continuously or discretely in time. By contrast, cash
dividends of fixed size (not contingent on the stock price prevailing on
the dividend date) have been given treatments varying both in content and
ease of use.1
The most straightforward approach is to assume that fixed dividends
do not affect the instantaneous volatility of a stock’s price2:
 
dS =  rS − ∑ ∆ iδ (t − τi ) dt + σSdW
 i  X n (T ) = ∑
This representation (referred to below as the ‘spot model’) is perhaps clos-
est to the intuition of traders. It is analytically awkward, as even plain Eu-
ropean-style options have no known closed solution. It is also potentially
tedious in Monte Carlo simulation and other integration methods. How-
ever, it can be easily accommodated in numerical schemes involving finite
difference (including the special case of a binomial tree).
At the other end of the spectrum is the popular recipe of subtracting
the present value of the fixed dividend stream from the current stock price
and applying zero-dividend Black-Scholes from there. This is usually jus-
tified with reference to a ‘risk-free’ and ‘risky’ part of the stock price. The
dividends over the tenor of the contract are considered ‘risk-free’, while
the ‘risky’ remainder follows a lognormal process:
S = X + S′
X = ∑ ∆ i exp ( −r τi )
i a forward contract.
dS ′ = rS ′ + σ ′S ′dW ′
Alternatively (and more practically), S′ is, up to multiplication by a divi-
dend-independent future value factor, the forward price of the stock, which
is assumed to be lognormal in this framework, and σ′ is therefore the
volatility of the forward price.
While subtraction from the stock price has the advantage of computa-
tional simplicity and attendant speed of evaluation, it has problems:

The price-adjusted option formula violates a perfectly reasonable con-
tinuity requirement: an extra dividend paid just before expiry should be
equivalent to an increase in the strike by the ex-dividend amount. Mathe-
matically, this failure comes about because subtracting (the present value
of) an amount from the price input of the Black-Scholes formula is not
equivalent to adding that amount to the strike input.

The volatility of the forward price of the stock relates awkwardly to the
historical volatility measures that are used to gauge option pricing. The his-
torical volatility as commonly calculated3 corresponds to the ‘spot’ volatility
σ above4, rather than σ′. For one thing, the volatility of the forward depends
on the time to expiry of the trade. To produce the same plain option price,
σ′, which operates only on the dividend-subtracted stock price, must be
higher than σ. This difference increases with the duration of the contract.
The aim of this article is to show that with a simple variation of stock
price adjustment, one may remain in the context of the spot, rather than
forward, model, yet have an analytical generalisation of Black-Scholes. This
approximation is largely indistinguishable from the results obtained by nu-
merical methods, but provides for faster evaluation where speed is of the
essence. (It has been used for many years within Lehman Brothers’ equi-
ty option analytics.)
For plain European-style options, the formula that achieves this effect
is constructed as follows. Divide the present value of the dividends fore-
cast up to expiry T in two pieces, a ‘near’ and a ‘far’ part:
T − τi
∆ i exp ( −r τi )
i T
τi
X f (T ) = ∑ ∆ i exp ( −r τi )
i T
A dividend about to occur (τi = 0) contributes exclusively to the ‘near’ part,
whereas a dividend just before expiry (τi = T) lives entirely in the ‘far’ piece.
Then, if C0(S, K) is the Black-Scholes premium of an option struck at K
on a stock with current price S and zero dividend, the premium for a stock
paying a fixed cash dividend stream is represented by:
(
C ( S, K ) = C0 S − X n , K + X f exp (rT ) )
This mixed adjustment formula shares with pure stock subtraction a num-
ber of desirable properties:

It is no more expensive to evaluate than the Black-Scholes formula itself.

The difference between a call and a put reproduces the exact value of

The ex-dividend behaviour is as required: if Xnn is obtained from Xn by
removing dividend i with τi = 0:
S − X n = ( S − ∆ i ) − X nn
However, it also corrects the flaws:

It behaves properly if a dividend date is moved across expiry: if Xff is
obtained from Xf by removing dividend i with τi = T:
K + X f exp (rT ) = ( K + ∆ i ) + X ff exp (rT )

It agrees with the results of a numerical evaluation of the spot model,
allowing the volatility input of the adjustment process to be interpreted as
the volatility of the spot price, rather than the forward price.
The latter point is illustrated by tables A and B. Table A lists at-the-
1 See, eg, V Frishling in Risk January 2002, pages 115–116, and references therein
2 Notation: the times τi are the ex-dates for the fixed dividends ∆i; δ(.) is the Dirac delta
function
3 Whether or not the time series used to compute historical volatility is adjusted for the
effect of historical dividends has no bearing on the following distinction
4 This point is also made by E Berger and D Klein in Bloomberg Magazine 7(7), 1998,
pages 116–120
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Cutting edge l Equity options

A. Premium of a call option as a function of B. Premium of a call option as a function of

time to expiry under different cash dividend strike under different cash dividends
treatments treatments
Expiry Spot Price Price/strike Method of Current Vega Strike Spot Price Price/strike Method of Current Vega
model adjustment adjustment moments yield model adjustment adjustment moments yield
1 year 10.66 10.47 10.66 10.66 10.49 0.38 75 33.75 32.35 33.81 32.35 31.91 0.53
3 years 18.60 17.69 18.60 18.51 17.61 0.61 100 23.70 21.91 23.69 23.38 21.55 0.73
5 years 23.70 21.91 23.69 23.38 21.55 0.73 125 16.58 14.74 16.52 16.39 14.46 0.81
7 years 27.47 24.75 27.44 26.79 23.93 0.80 150 11.65 9.94 11.54 11.56 9.73 0.79

Assumptions: stock price 100, strike 100, volatility 25%, stock funding and Assumptions: stock price 100, expiry five years, volatility 25%, stock funding
discount rate 6%, cash dividend of 4 in the middle of every year and discount rate 6%, cash dividend of 4 in the middle of every year

money call premiums as a function of expiry under the various methods:
a finite difference (or, for that matter, binomial tree) evaluation of the spot
model, the price adjustment and the mixed price/strike adjustment.5 Table
B similarly displays the behaviour of these approaches under different
strikes at fixed expiry. In all cases, the ‘face value’ volatility input is taken
to be the same.
While the price adjustment diverges markedly from the spot-based
model, the mixed adjustment agrees with it. This is particularly clear if
the differences are judged against the vega of the contracts, which mea-
sures the resolution of most traders’ pricing practice. At-the-money, the
pure price adjustment differs from a spot model anchored in standard
historical volatility by half a volatility point for one year, increasing to
three-and-a-half points over seven years. This is definitely above com-
monly accepted pricing noise. The mixed adjustment, on the other hand,
is within 0.05 volatility points of the spot process, even over seven years.
No trader of our acquaintance can discern that kind of variation in the
behaviour of a stock.
Why does the mixed adjustment reproduce the spot model so well?
As an approximation to the spot process, subtraction from the price alone
underestimates plain option values. If, instead of subtracting all dividends
from the price, one were to add them all to the strike, overestimates
would ensue. This suggests a mixed adjustment, which must be time-de-
pendent to satisfy the ex-dividend constraint and the strike behaviour
that pin down dividends at the extremes. The interpolation advocated
here has the merit (other than simplicity) of approximately solving the
spot model Black-Scholes differential equation if cash dividends are treat-
ed by linear perturbation. This point is elaborated in the appendix.
The stochastic process implied by the mixed adjustment procedure is:
 σ2  
St = ( S0 − X n (t )) exp   r −  t + σWt  − X f (t ) exp (rt )
 2 
This could be thought of as an approximate integration of the spot model,
or as a viable dynamical model in its own right. Either way, this repre-
sentation easily fits into most standard numerical techniques. It particular-
ly facilitates Monte Carlo simulations by incorporating the effects of multiple
dividends in a single stochastic step. It also leads to simple explicit Green’s
functions for use in numerical integration. ■
Michael Bos is managing director and Stephen Vandermark is senior
vice-president in the equity quantitative analytics group at Lehman
Brothers
5 For comparison, it also includes a method-of-moments approach (where the stock price
at expiry is assigned a lognormal distribution whose first two moments agree with those
calculated from the spot model) as well as a yield-based calculation (where the current
yield substitutes for the cash dividend schedule)

Appendix
The specific time dependence of the mixed adjustment weights aris-
 ∂C ∂C 0  df
es more or less naturally in a first-order perturbative treatment of the ∆  *0 + exp (r (T − t ))
Black-Scholes differential equation.  ∂S ∂K *  dt
Consider a plain option of strike K expiring at time T as seen from
∂ 2C0  
∆Sf − ∆ 2 exp ( −r ( τ − t )) f 2 
1
time t. Assume the stock pays a single dividend ∆ at time τ. The dif- = σ2 *2 
 
ferential equation for the spot model is: ∂S 2

∂C ∂C 1 2 2 ∂ 2C
+ (rS − ∆δ (t − τ )) + σ S − rcC = 0 In the linear perturbative approximation, the ∆2 contribution on the
∂t ∂S 2 ∂S 2 right and the distinction between S* and S may be neglected. For
parameters not too far away-from-the-money:
where r is the stock funding rate and rc is the option carry rate. Try
forward-preserving input adjustment solutions of the form: ∂C 0 ∂C 0 ∂ 2C0
+ exp (r (T − t )) ≅ (T − t ) σ 2 S
(
C ( S , K ) = C0 S * , K * ) leading to:
∂S ∂K ∂S 2

where C0 is Black-Scholes for zero dividend and: df f

=
dt T − t
S* = S − f (t ) ∆ exp ( −r ( τ − t )) Given the boundary condition F(t = τ) = 1, the solution is:
K = K + (1 − f (t )) ∆ exp (r (T − τ ))
*
T −τ
f (t ) =
Substitution in the partial differential equation for t < τ leads to: T −t

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