Dividend Forecast Biases in Index Option Valuation

Don Chance, Raman Kumar and Don Rich

Review of Derivatives Research, 2000, vol. 4, issue 3, 285-303

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

Keywords: index options; option pricing; dividend forecasting (search for similar items in EconPapers)
Date: 2000
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DOI: 10.1023/A:1011335530815

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