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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Path-Dependent Dividends
and the American Put Option
M.H. Vellekoop
1
J.W. Nieuwenhuis
2
1
Department of Applied Mathematics
University of Twente
2
Department of Economics and Business Administration
University of Groningen
Numerical Methods in Finance, Paris 2009
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Outline
1
Problem Formulation
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
2
Main Theorem
Early Exercise Premium with Dividends
Calculating the Optimal Exercise Boundary
3
Numerical Results
Knock Out Dividend Model
Proportional Cash Dividend Model
Fixed Cash Dividend Model
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
Standard Equity Model
Consider the standard Black-Scholes-Merton model for stock and bond prices
dS
t
= rS
t
dt + S
t
dW
t
dB
t
= rB
t
dt
for time period t [0, T] with
S
0
, B
0
, r , given strictly positive constants and
W a one-dimensional Brownian Motion on the ltered probability space
(, F, (F
t
)
t [0,T]
, Q).
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
American and European Put Options
Let AP and EP denote the American and European Put price processes for
the maturity T and a strike K > 0:
EP
t
= E
Q
[
B
t
B
T
(K S
T
)
+
| F
t
]
def
= E(t , S
t
)
AP
t
= ess sup
T
[t ,T]
E
Q
[
B
t
B

(K S

)
+
| F
t
]
def
= A(t , S
t
)
where T
[t ,T]
is the set of all stopping times with values in [t , T].
Optimal stopping problem for American Put has the solution

= inf{u t : A(u, S
u
) = (K S
u
)
+
} = inf{u t : S
u
S

u
}
where S

denotes what is called the optimal exercise boundary.


Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
Early Exercise Premium
The difference between the American and European option price is known as
the Early Exercise Premium
EE(t , s) = A(t , s) E(t , s)
and it can be characterized as follows:
Early Exercise Representation
(Carr et al 92), (Jacka 93), (Kim 90)
EE(t , s) = rK E
Q
[

T
t
e
r (ut )
1
{S
u
S

u
}
du | S
t
= s ]
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
Dividend Models
We would like to extend these results to the case where dividends are
included, i.e.
dS
t
= rS
t
dt + S
t
dW
t
dD
S
t
with, for example, continuous, proportional or xed cash dividends
dD
S
t
= qS
t
dt
dD
S
t
= (1 )S
t
d1
{t t
D
}
dD
S
t
= min{d, S
t
}d1
{t t
D
}
.
for a given t
D
]0, T[ and d > 0, q > 0, , ]0, 1[.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
Path-Dependent Dividend
Here, we focus on knock-out version of proportional dividends:
dD
S
t
= (1 )S
t
1
{ min
u[0,t
d
]
S
u
S
0
}
d1
{t t
d
}
This models the fact that the company which issued the stock will only pay
dividends if the stock price has not fallen below the level S
0
before the
dividend date.
This obviously makes the dividend path-dependent.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
Path-Dependent Dividend
European Put option with knockout dividends can be priced in closed form:
Lemma
For general ]0, 1] and m
t
S
0
we have that the European put option
price E(t , S
t
) with strike K and maturity T equals, for all t [0, T],
P
K,T
(t , S
t
) + 1
{t <t
d
}
Ke
r (Tt )

h
t
d
,T
(S
0
, K) L

t

h
t
d
,T
(
S
t
L
t
,
K
L
2
t
)

1
{t <t
d
}
e
r (Tt )

H
t
d
,T
(S
0
, K) L
2+
t

H
t
d
,T
(
S
t
L
t
,
K
L
2
t
)

with L
t
=
S
0
S
t
, = 2r
2
1 and

H
t
1
,t
2
(x
1
, x
2
) = E
Q
[

S
t
2
1
{

S
t
2

x
2

,

S
t
1
>x
1
}
| F
t
]
E
Q
[

S
t
2
1
{

S
t
2
x
2
,

S
t
1
>x
1
}
| F
t
]

h
t
1
,t
2
(x
1
, x
2
) = Q(

S
t
1
> x
1
, x
2
<

S
t
2

x
2

| F
t
)
where

S is the asset process with zero dividends.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
Dividend Model Assumptions
In more general setup, we assume
1
S is an adapted cdlg semimartingale, Markov, and distribution of S
t
has a density for all t
2
D
S
is an adapted, increasing cdlg semimartingale, continuous in all
but countable number of time points
3
S/B +

dD
S
/B is a Q-martingale, and the functions
x E
Q
[(S
u
) | S
t
= x], x E
Q
[

u
t
dD
S
v
/B
v
| S
t
= x]
are increasing for all 0 t < u T and for all increasing functions
: R R.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions
Dividend Model Assumptions
These assumptions include the dividend models mentioned earlier, but also
stock-dependent volatility models (Babilua et al. 07).
They guarantee that if we dene
S

t
= inf{s > 0 : A(t , s) > K s}
then
s > S

t
A(t , s) > K s
i.e. it excludes possibility that there
are several boundaries which
separate different continuation and
stopping regions.
dD
S
t
= min{S
t
D

, max{40 S
t
D

, 0}}d1
{t t
D
}
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Early Exercise Premium with Dividends
Calculating the Optimal Exercise Boundary
Early Exercise Premium with Dividends
For stock price models with dividends, the early exercise premium can be
characterized as follows:
Theorem (Early Exercise Representation including Dividends)
Under the assumptions stated above, and the additional assumption that the
optimal exercise boundary S

is continuous apart from at most a countable


number of points, the American and European Put price processes satisfy
AP
t
EP
t
= B
t
E
Q
[

T
t
1
{S
u
S

u
S
u
=0}
(d(
K
B
u
) +
dD
S
u
B
u
) | F
t
].
Continuity of optimal exercise boundary is subject of ongoing research, in
collaboration with CERMICS.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Early Exercise Premium with Dividends
Calculating the Optimal Exercise Boundary
Part I
First prove that s A(t , s) is Lipschitz continuous, uniformly over t
Apply Meyer-Ito formula for convex mappings to the process
X = (AP K + S)/B.
Use the fact that AP/B, as Snell envelope of upper semicontinuous
process, is a continuous positive supermartingale, and
that S

t
is continuous apart from a countable number of points,
to show that the local time of X in zero equals zero.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Early Exercise Premium with Dividends
Calculating the Optimal Exercise Boundary
Part II
Since S/B +

dD
S
/B is a Q-martingale, it turns out that the remaining
technical point is to prove that

t
0
1
{S
u
>S

u
}
d(
AP
u
B
u
)
is also a martingale under Q.
We do this by extending earlier dened methods (El Karoui 79, Karatzas
& Shreve 88, Jacka 93) for optimal stopping problems, exploiting the
fact that we may show that we should never stop in points where S is
discontinuous.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Early Exercise Premium with Dividends
Calculating the Optimal Exercise Boundary
Integral equation for Optimal Exercise Boundary
Inserting s = S

t
as initial condition at time t gives
Corollary
Under the assumptions of the previous theorem, the optimal exercise
boundary satises
K S

t
=
E(t , S

t
) B
t
E
Q
[

T
t
1
{S
u
S

u
S
u
=0}
(d(
K
B
u
) +
dD
S
u
B
u
) | S
t
= S

t
].
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Knock Out Dividend Model
Proportional Cash Dividend Model
Fixed Cash Dividend Model
Knock Out Dividend Model
Equity model
dS
t
= rS
t
dt + S
t
dW
t
dD
S
t
dD
S
t
= (1 )S
t
1
{ min
u[0,t
d
]
S
u
S
0
}
d1
{t t
d
}
.
Parameter values
S
0
= K = 100, = 0.50, r = 0.125, T = 0.50, t
D
= 0.30, = .99, = .20.
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
0
10
20
30
40
50
60
70
80
90
100
Time
O
p
t
i
m
a
l

E
x
e
r
c
i
s
e

B
o
u
n
d
a
r
y
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Knock Out Dividend Model
Proportional Cash Dividend Model
Fixed Cash Dividend Model
Proportional Cash Dividend Model
Equity model
dS
t
= rS
t
dt + S
t
dW
t
dD
S
t
dD
S
t
= (1 )S
t
d1
{t t
D
}
.
Parameter values
S
0
= 100, = 0.30, r = 0.04, K = 100, T = 2.00, t
D
= 1.50, = 0.98
0 0.5 1 1.5 2
0
10
20
30
40
50
60
70
80
90
100
Time
O
p
t
i
m
a
l

E
x
e
r
c
i
s
e

B
o
u
n
d
a
r
y
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Knock Out Dividend Model
Proportional Cash Dividend Model
Fixed Cash Dividend Model
Fixed Cash Dividend Model
Equity model
dS
t
= rS
t
dt + S
t
dW
t
dD
S
t
dD
S
t
= min{D, S
t
}d1
{t t
D
}
.
results in following integral equation
EEP(t , s) = rK

t
d
t
e
r (ut )
N(
ln(S

u
/s)r (ut )

ut
)du
+ rKe
r (t
d
t )

T
t
d


z
N(
ln(se
r (t
d
t )+x

t
d
t
D)ln S

u
+r (ut
d
)

ut
d
)dN(x)du
where
z =
ln(D/s) r (t
d
t )

t
d
t
.
and where N is the cumulative standard normal distribution function.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Knock Out Dividend Model
Proportional Cash Dividend Model
Fixed Cash Dividend Model
Fixed Cash Dividend Model
Equity model
dS
t
= rS
t
dt + S
t
dW
t
dD
S
t
dD
S
t
= min{d, S
t
}d1
{t t
D
}
.
Parameter values
S
0
= 100, = 0.30, r = 0.04, K = 100, T = 2.00, t
D
= 1.50, d = 5.
0 0.5 1 1.5 2
0
10
20
30
40
50
60
70
80
90
100
Time
O
p
t
i
m
a
l

E
x
e
r
c
i
s
e

B
o
u
n
d
a
r
y
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Problem Formulation
Main Theorem
Numerical Results
Conclusions
Conclusions
We extended the early exercise representation formula to a rather
general model for stocks with knock-out dividends.
However, we need to assume that the optimal exercise boundary is
continuous apart from a countable number of points in time.
Establishing how to prove this a priori is known to be hard, and is the
subject of ongoing research.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Appendix References
References I
P. Babilua, I. Bokuchava, B. Dochviri, and M. Shashiashvili.
The American put option in a one-dimensional diffusion model with
level-dependent volatility.
Stochastics, 79:525, 2007.
P. Carr, R. Jarrow, and R. Myneni.
Alternative characterizations of American puts.
Mathematical Finance, 2:87106, 1992.
N. El Karoui.
Les aspects probabilistes du contrle stochastique, Lecture Notes in
Mathematics 876.
Springer-Verlag, Berlin, 1981.
S.D. Jacka.
Local times, optimal stopping and semimartingales.
Annals of Probability, 21:329339, 1993.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option
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Appendix References
References II
S. Kallast and A. Kivinukk.
Pricing and hedging American options using approximations by Kim
integral equations.
European Finance Review, 7:361383, 2003.
I.J. Kim.
The analytical valuation of American options.
Review of Financial Studies, 3:547472, 1990.
G. Peskir.
On the American option problem.
Mathematical Finance, 15:169181, 2005.
Vellekoop & Nieuwenhuis Path-Dependent Dividends and the American Put Option