Back to Basics: a new approach to the discrete dividend problem

∗We would like to thank Samuel Siren, Paul Wilmott, and participants in the Wilmott forum (www.wilmott.com) for useful comments and suggestions. All the usual disclaimers apply. †J.P. Morgan ‡Norwegian School of Economics and Business Administration §OptionCity.net An alternative to discrete cash dividend is discrete dividend yield. Implementation of discrete dividend yield is well known and straight forward using recombining lattice models (see for instance Haug, 1997; Hull, 2000). Typically, however, at least the first dividend is known in advance with some confidence. Discrete cash dividend models consequently seem to have been the models of choice among practitioners, despite having to deal with a more complex modelling problem. For very long term options the predictability of future dividends is less pronounced, and dividends should be somewhat correlated with the stock price level. Moreover, cash dividends tend to be reduced following a significant stock price decrease. If the stock price rallies, on the other hand, it indicates that the company is doing better than expected, which again can