American Options with Stochastic Dividends and Volatility: A Nonparametric Investigation

Posted: 14 Nov 1996

See all articles by Mark Broadie

Mark Broadie

Columbia University - Columbia Business School - Decision Risk and Operations

Jerome Detemple

Boston University - Department of Finance & Economics; Center for Interuniversity Research and Analysis on Organization (CIRANO)

Eric Ghysels

University of North Carolina Kenan-Flagler Business School; University of North Carolina (UNC) at Chapel Hill - Department of Economics

Olivier Torres

Universite Catholique de Louvain

Date Written: Undated

Abstract

In this paper, we consider American option contracts when the underlying asset has stochastic dividends and stochastic volatility. We provide a full discussion of the theoretical foundations of American option valuation and exercise boundaries. We show how they depend on the various sources of uncertainty which drive dividend rates and volatility, and derive equilibrium asset prices, derivative prices and optimal exercise boundaries in a general equilibrium model. The theoretical models yield fairly complex expressions which are difficult to estimate. We therefore adopt a nonparametric approach which enables us to investigate reduced forms. Indeed, we use nonparametric methods to estimate call prices and exercise boundaries conditional on dividends and volatility. Since the latter is a latent process, we propose several approaches, notably using EGARCH filtered estimates, implied and historical volatilities. The nonparametric approach allows us to test whether call prices and exercise decisions are primarily driven by dividends, as has been advocated by Harvey and Whaley (1992a,b) and Fleming and Whaley (1994) for the OEX contract, or whether stochastic volatility complements dividend uncertainty. We find that dividends alone do not account for all aspects of call option pricing and exercise decisions, suggesting a need to include stochastic volatility.

JEL Classification: G10, G13

Suggested Citation

Broadie, Mark and Detemple, Jerome and Ghysels, Eric and Torres, Olivier, American Options with Stochastic Dividends and Volatility: A Nonparametric Investigation (Undated). Available at SSRN: https://ssrn.com/abstract=7903

Mark Broadie (Contact Author)

Columbia University - Columbia Business School - Decision Risk and Operations ( email )

New York, NY
United States
212-854-4103 (Phone)

Jerome Detemple

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 353-4297 (Phone)
(617) 353 6667 (Fax)

Center for Interuniversity Research and Analysis on Organization (CIRANO)

2020 rue University, 25th Floor
Montreal, Quebec H3C 3J7
Canada

Eric Ghysels

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Gardner Hall, CB 3305
Chapel Hill, NC 27599
United States
919-966-5325 (Phone)
919-966-4986 (Fax)

HOME PAGE: http://www.unc.edu/~eghysels/

Olivier Torres

Universite Catholique de Louvain ( email )

Place Montesquieu, 3
B-1348 Louvain-la-Neuve, 1348
Belgium

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