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Dividend Forecast Biases in Index Option Valuation

Author

Listed:
  • Don Chance
  • Raman Kumar
  • Don Rich

Abstract

Since the early days of option pricing theory,the assumption that the dividends on the underlying stock or index over the life of the contract are known has not been challenged. We examine the sensitivity of index option prices to the assumption of dividend uncertainty. We consider a number of issues related to the forecasting of dividends and build a dividend forecasting model that passes several rigorous tests for unbiasedness. We then generate option prices using contemporary market levels and interest rates. We find that prices generated with the actual dividends are unbiased with respect to those generated using the forecasted dividends. The magnitudes of the forecast errors, however, are sufficiently large to suggest a concern, but the percentage errors are consistently small, typically amounting to less than two percent of the option price. We conclude that the convenient assumption that the stream of future dividendsis known is probably innocuous. Copyright Kluwer Academic Publishers 2000

Suggested Citation

  • Don Chance & Raman Kumar & Don Rich, 2000. "Dividend Forecast Biases in Index Option Valuation," Review of Derivatives Research, Springer, vol. 4(3), pages 285-303, October.
    • Handle: RePEc:kap:revdev:v:4:y:2000:i:3:p:285-303
    DOI: 10.1023/A:1011335530815
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    References listed on IDEAS

    as
    1. Roll, Richard, 1977. "An analytic valuation formula for unprotected American call options on stocks with known dividends," Journal of Financial Economics, Elsevier, vol. 5(2), pages 251-258, November.
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    3. Cornell, Bradford & French, Kenneth R, 1983. "Taxes and the Pricing of Stock Index Futures," Journal of Finance, American Finance Association, vol. 38(3), pages 675-694, June.
    4. Sheikh, Aamir M., 1991. "Transaction Data Tests of S&P 100 Call Option Pricing," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(4), pages 459-475, December.
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