The Pricing of Vanilla Options with Cash Dividends as a Classic Vanilla Basket Option Problem

TL;DR

This paper investigates the use of basket option formulas to approximate vanilla option prices on dividend-paying stocks within a piecewise lognormal model, addressing the lack of closed-form solutions.

Contribution

It introduces a novel approach by applying basket option pricing formulas to model vanilla options with discrete dividends, offering an alternative to existing approximations.

Findings

Basket formulas provide accurate approximations for vanilla options with dividends.

The method simplifies pricing in the piecewise lognormal model.

Results outperform some traditional approximation techniques.

Abstract

In the standard Black-Scholes-Merton framework, dividends are represented as a continuous dividend yield and the pricing of Vanilla options on a stock is achieved through the well-known Black-Scholes formula. In reality however, stocks pay a discrete fixed cash dividend at each dividend ex-date. This leads to the so-called piecewise lognormal model, where the asset jumps from a fixed known amount at each dividend date. There is however no exact closed-form formula for the pricing of Vanilla options under this model. Approximations must be used. While there exists many approximations taylored to this specific problem in the litterature, this paper explores the use of existing well-known basket option formulas for the pricing of European options on a single asset with cash dividends in the piecewise lognormal model.