An Alternative Approach to Dividend Adjustments in Option Pricing Models

This article examines the valuation of European as well as American call options when the underlying asset pays dividends during the life of the options. An alternative way to adjust option valuation formulas for dividends is proposed. For European options, this proposed alternative is compared with the traditional approaches and the reasons differences arise are explored. For American options, the alternative approach allows us to extend the known-dividend models of Roll, and Jarrow and Rudd. A closed form solution is derived and is shown to be potentially able to correct the exercise price related biases reported for the Black and Scholes formula.