Dividend Forecast Biases in Index Option Valuation

Authors: Chance D.M.¹; Kumar R.²; Rich D.³

Source: Review of Derivatives Research, Volume 4, Number 3, 2000 , pp. 285-303(19)

Publisher: Springer

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Abstract:

Since the early days of option pricing theory, the assumption that the dividends on the underlying stock or index over the life of the contract are known has not been challenged. We examine the sensitivity of index option prices to the assumption of dividend uncertainty. We consider a number of issues related to the forecasting of dividends and build a dividend forecasting model that passes several rigorous tests for unbiasedness. We then generate option prices using contemporary market levels and interest rates. We find that prices generated with the actual dividends are unbiased with respect to those generated using the forecasted dividends. The magnitudes of the forecast errors, however, are sufficiently large to suggest a concern, but the percentage errors are consistently small, typically amounting to less than two percent of the option price. We conclude that the convenient assumption that the stream of future dividends is known is probably innocuous.

Keywords: index options; option pricing; dividend forecasting

Language: English

Document Type: Regular paper

Affiliations: 1: First Union Professor of Financial Risk Management, Pamplin College of Business, Virginia Tech, Blacksburg, Virginia 24061 2: Professor of Finance, Pamplin College of Business, Virginia Tech, Blacksburg, Virginia 24061 3: Associate Professor of Finance, College of Business Administration, 413 Hayden Hall-CBA, Northeastern University, Boston, MA 02115

Publication date: 2000-01-01