Problem Formulation

Main Theorem
Numerical Results
Conclusions

Path-Dependent Dividends
and the American Put Option
M.H. Vellekoop1
1

J.W. Nieuwenhuis2

Department of Applied Mathematics

University of Twente

Department of Economics and Business Administration

University of Groningen

Numerical Methods in Finance, Paris 2009

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

Problem Formulation
Main Theorem
Numerical Results
Conclusions

Outline

Problem Formulation
Standard Black-Scholes-Merton Model
Including Dividends
Assumptions

Main Theorem
Early Exercise Premium with Dividends
Calculating the Optimal Exercise Boundary

Numerical Results
Knock Out Dividend Model
Proportional Cash Dividend Model
Fixed Cash Dividend Model
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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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
dSt

rSt dt + St dWt

dBt

rBt dt

for time period t [0, T ] with

S0 , B0 , r , given strictly positive constants and
W a one-dimensional Brownian Motion on the filtered probability space
(, F , (Ft )t[0,T ] , Q).

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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:
def

EPt

EQ [ BBt (K ST )+ | Ft ] = E(t, St )

APt

ess sup EQ [ BBt (K S )+ | Ft ] = A(t, St )

def

T[t,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, Su ) = (K Su )+ } = inf{u t : Su Su }
where S denotes what is called the optimal exercise boundary.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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)
Z T
EE(t, s) = rK EQ [
er (ut) 1{Su Su } du | St = s ]
t

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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.
dSt

rSt dt + St dWt dDtS

with, for example, continuous, proportional or fixed cash dividends

dDtS

dDtS

(1 )St d1{ttD }

dDtS

min{d, St }d1{ttD } .

qSt dt

for a given tD ]0, T [ and d > 0, q > 0, , ]0, 1[.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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:

dDtS

(1 )St 1{ min S S } d1{ttd }

u
0
u[0,td ]

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 S0 before the
dividend date.
This obviously makes the dividend path-dependent.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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 mt S0 we have that the European put option
price E(t, St ) with strike K and maturity T equals, for all t [0, T ],


t ,T (S0 , K ) L h
t ,T ( St , K2 )
PK ,T (t, St ) + 1{t<td } Ker (T t) h
t
d
d
Lt L
t


t ,T (S0 , K ) L2+ H
t ,T ( St , K2 )
1{t<td } er (T t) H
t
d
d
Lt L
t

with Lt =

S0
,
St

= 2r 2 1 and

t ,t (x1 , x2 )
H
1 2

t 1
EQ [S
2 {S

t2

t 1
EQ [S
2 {St
t ,t (x1 , x2 )
h
1 2

x2
, St >x1 }

| Ft ]

>x }
x2 , S
t
1

| Ft ]

t > x1 , x2 < S
t
Q(S
1
2

x2

| Ft )

is the asset process with zero dividends.

where 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 Model Assumptions

In more general setup, we assume

1

S is an adapted cdlg semimartingale, Markov, and distribution of St

has a density for all t
D S is an adapted, increasing cdlg semimartingale, continuous in all
but countable number of time points
R
S/B + dD S /B is a Q-martingale, and the functions
Z u
x EQ [(Su ) | St = x],
x EQ [
dDvS /Bv | St = x]
t

are increasing for all 0 t < u T and for all increasing functions
: R R.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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

A(t, s) > K s

i.e. it excludes possibility that there

are several boundaries which
separate different continuation and
stopping regions.

dDtS = min{St , max{40 St , 0}}d1{tt }

D
D
D
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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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
Z T
dD S
APt EPt = Bt EQ [
1{Su Su Su =0} (d( BKu ) + Buu ) | Ft ].
t

Continuity of optimal exercise boundary is subject of ongoing research, in

collaboration with CERMICS.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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 St is continuous apart from a countable number of points,
to show that the local time of X in zero equals zero.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

Problem Formulation
Main Theorem
Numerical Results
Conclusions

Early Exercise Premium with Dividends

Calculating the Optimal Exercise Boundary

Part II

R
Since S/B + dD S /B is a Q-martingale, it turns out that the remaining
technical point is to prove that
Z t
u
1{Su >Su } d( AP
)
Bu
0

is also a martingale under Q.

We do this by extending earlier defined 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.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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 = St as initial condition at time t gives

Corollary
Under the assumptions of the previous theorem, the optimal exercise
boundary satisfies
K St =
E(t, St ) Bt EQ [

Z
t

1{Su Su Su =0} (d( BKu ) +

dDuS
Bu

) | St = St ].

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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
dSt

rSt dt + St dWt dDtS

dDtS

(1 )St 1{ min S S } d1{ttd } .

u
0
u[0,td ]

Parameter values
S0 = K = 100, = 0.50, r = 0.125, T = 0.50, tD = 0.30, = .99, = .20.
100
90

Optimal Exercise Boundary

80
70
60
50
40
30
20
10
0

0.05

0.1

0.15

0.2

0.25
Time

0.3

0.35

0.4

0.45

0.5

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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
dSt

rSt dt + St dWt dDtS

dDtS

(1 )St d1{ttD } .

Parameter values
S0 = 100, = 0.30, r = 0.04, K = 100, T = 2.00, tD = 1.50, = 0.98
100
90

Optimal Exercise Boundary

80
70
60
50
40
30
20
10
0

0.5

1
Time

Vellekoop & Nieuwenhuis

1.5

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Path-Dependent Dividends and the American Put Option

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
dSt

rSt dt + St dWt dDtS

dDtS

min{D, St }d1{ttD } .

results in following integral equation

EEP(t, s)

rK

Z t

r (ut)
d er (ut) N( ln(Su /s)

)du
ut
t

+ rKe

r (td t)

Z T Z
td

N(

r (t t)+x
ln(se d

where
z =

td t
+r (ut )
D)ln Su
d )dN(x)du
p
utd

ln(D/s) r (td t)
.
p
td t

and where N is the cumulative standard normal distribution function.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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
dSt

rSt dt + St dWt dDtS

dDtS

min{d, St }d1{ttD } .

Parameter values
S0 = 100, = 0.30, r = 0.04, K = 100, T = 2.00, tD = 1.50, d = 5.
100
90

Optimal Exercise Boundary

80
70
60
50
40
30
20
10
0

0.5

1
Time

Vellekoop & Nieuwenhuis

1.5

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Path-Dependent Dividends and the American Put Option

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.

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Path-Dependent Dividends and the American Put Option

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.
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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option

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.

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Vellekoop & Nieuwenhuis

Path-Dependent Dividends and the American Put Option