Dividend-Rollover Effect and the Ad Hoc Black-Scholes Model

Journal of Futures Markets, Vol. 32, No. 8, pp. 742-772, 2012

Posted: 17 Sep 2012

See all articles by Youngsoo Choi

Youngsoo Choi

Hankuk University of Foreign Studies

Steven J. Jordan

Econometric Solutions

Soonchan Ok

e*Learn

Date Written: August 1, 2012

Abstract

One of the most widely used option-valuation models among practitioners is the ad hoc Black-Scholes (AHBS) model. The main contribution of this study is methodological. We carefully consider three dividend strategies (No dividend, Implied-forward dividend, and Actual dividend) for the AHBS model to investigate their effect on pricing errors. We suggest a new dividend strategy, implied-forward dividend, which incorporates expectational information on dividends embedded in option prices. We demonstrate that our implied-forward dividend strategy produces more consistent estimates between in-sample market and model option prices. More importantly our new implied-forward dividend strategy makes more accurate out-of-sample forecasts for one-day or one-week ahead prices.

Second, we document that both a “Return-volatility” Smile and a “Return-pricing Error” Smile exist. From these return characteristics, we make two conclusions: (1) the return dependency of implied volatility is an important explanatory variable and should be controlled to reduce the pricing error of an AHBS model, and (2) it is important for the hedging horizon to be based on return size, that is, the larger the contemporaneous return, the more frequent an option issuer must rebalance the option’s hedge.

Keywords: Dividends, Black-Scholes, Ad hac, Implied, Volatility, IVOL, AHBS, Expectations, Forward, Hedging

Suggested Citation

Choi, Youngsoo and Jordan, Steven J. and Ok, Soonchan, Dividend-Rollover Effect and the Ad Hoc Black-Scholes Model (August 1, 2012). Journal of Futures Markets, Vol. 32, No. 8, pp. 742-772, 2012, Available at SSRN: https://ssrn.com/abstract=2147460

Youngsoo Choi (Contact Author)

Hankuk University of Foreign Studies ( email )

89 Wangsan-ri, Mohyeon-myeon, Cheoin-gu
Yongin-shi, Kyonggi-do 449-791
Korea, Republic of (South Korea)

Steven J. Jordan

Econometric Solutions ( email )

3520 Fossil Park Dr.
Fort Worth, TX NA 76137
United States

Soonchan Ok

e*Learn ( email )

Kwanghwamun Bldg. 4th fl.
211 Sejongro, Jongrogu
Seoul, 110-730
Korea, Republic of (South Korea)

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