Universal Bad News Principle and Pricing of Options on Dividend-Paying Assets

24 Pages Posted: 19 Mar 2004

See all articles by Svetlana Boyarchenko

Svetlana Boyarchenko

University of Texas at Austin - Department of Economics

Sergei Levendorskii

Calico Science Consulting

Date Written: March 14, 2004

Abstract

We solve the pricing problem for perpetual American puts and calls on dividend-paying assets. The dependence of a dividend process on the underlying stochastic factor is fairly general: any non-decreasing function is admissible. The stochastic factor follows a Levy process. This specification allows us to consider assets that pay no dividends at all when the level of the underlying factor (say, the assets of the firm) is too low, and assets that pay dividends at a fixed rate when the underlying stochastic process remains in some range. Certain dividend processes exhibiting mean-reverting features can be modelled as appropriate increasing functions of Levy processes. The pay-offs of the American call option can be represented as the expected present value (EPV) of a certain stream of payoffs: dividends minus qK, where K is the strike, and q the riskless rate (similarly for the put), and we show that the option must be exercised the first time the EPV of the stream of the payoffs, with the infimum process in place of the initial process, becomes positive. Thus, the exercise threshold depends only on the record setting bad news. The results can be applied to the theory of real options as well; as one of possible applications, we consider the problem of incremental capital expansion.

Keywords: Levy processes, option pricing, dividend paying assets

JEL Classification: C61, D81, G12

Suggested Citation

Boyarchenko, Svetlana I. and Levendorskii, Sergei Z., Universal Bad News Principle and Pricing of Options on Dividend-Paying Assets (March 14, 2004). Available at SSRN: https://ssrn.com/abstract=517383 or http://dx.doi.org/10.2139/ssrn.517383

Svetlana I. Boyarchenko (Contact Author)

University of Texas at Austin - Department of Economics ( email )

Austin, TX 78712
United States

Sergei Z. Levendorskii

Calico Science Consulting ( email )

Austin, TX
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
132
Abstract Views
1,096
rank
227,753
PlumX Metrics