Value of European put on Dividend paying Stock/ Dividend &

Theoretical Fair Value of European put

1. Known continuous dividend yield (Dividend in percentage basis):-

 If dividend yield at time 1 (t1).

o Step 1:- setting up adjusted stock price path:-

 Working note:
(i) Su = S0 x u
(ii) S’u = Su – (Su x dy)
= Su – D.
(iii) Sd = S0 x d
(iv) S’d = Sd – (Sd x dy)
= Sd – D.

Where,

S’u & S’d = stock price (up and down) after adjustment of dividend

dy = percentage of dividend

D = amount of dividend

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o Step 2 :- setting up put price path and calculation of intrinsic value of put at
time t2

Pu2 = Max (0,E - S’u2)

Pud = Max (0, E - S’ud)

Pd2 = Max (0,E - S’d2)

o Step 3 : calculation of probability:-

(1+𝑟)𝑡 −𝑑
Pr =
𝑢−𝑑
𝑒 𝑟𝑐𝑥𝑡
=
𝑢−𝑑
o Step 4 :- calculation of value of Put at time t1 :-

𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑

Pu =
(1+𝑟)
𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
Pd = (1+𝑟)

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡

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 o Step 5 :- calculation of theoretical fair value of put:-
𝑃𝑟 𝑥 𝑃𝑢+(1−𝑝𝑟)𝑥𝑃𝑑
P= (1+𝑟)𝑜𝑟 𝑒 𝑟𝑐𝑥𝑡

2. Known discrete Dividend (specific rupee dividend):-

(i) If dividend is paid at time t0
o Step 1: setting up adjusted stock price path:-

 Working note:
S’0 = S0 - D0

S’u = S’0 x u

S’d = S’0 xd

Where,

S’0 = stock price after adjustment of dividend

S’u & S’d = stock price (up and down) after adjustment of dividend

D0 = current dividend

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o Step 2 : setting up put price path and calculation of intrinsic value of put at
time t2 :-

Pu2 = Max (0,E - S’u2)

Pud = Max (0, E - S’ud)

Pd2 = Max (0, E - S’d2)

o Step 3 : calculation of probability:-

(1+𝑟)𝑡 −𝑑
Pr =
𝑢−𝑑
𝑒 𝑟𝑐𝑥𝑡
=
𝑢−𝑑
o Step 4 :- calculation of value of Put at time t :-

𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑

Pu =
(1+𝑟)
𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
Pd = (1+𝑟)

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡

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o Step 5 :- calculation of theoretical fair value of Put :-
𝑃𝑟 𝑥 𝑃𝑢+(1−𝑝𝑟)𝑥𝑃𝑑
P= (1+𝑟)𝑜𝑟 𝑒 𝑟𝑐𝑥𝑡

(ii) If dividend is paid at time t1 (Adjustment of dividend in time t1 Using

non-recombining Binomial tree approach):

Step 1: setting up adjusted stock price path (non-recombining

Binomial tree approach):

Working notes
S’u = Su – D1
S’d = Sd - D1
S’u2 = S’u x u
S’ud = S’u x d
S’du = S’d xu
S’d2 = S’d xd

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 o Step 2 : setting up put price path(non-recombining tree) and calculation of
intrinsic value of put at time t2 :-

Pu2 = Max (0, E - S’u2)

Pud = Max (0, E - S’ud)

Pdu = Max (0, E - S’du)

Pd2 = Max (0, E - S’d2)

Step 3: calculation of probability:-

(1+𝑟)𝑡 −𝑑
Pr =
𝑢−𝑑
𝑒 𝑟𝑐𝑥𝑡
=
𝑢−𝑑

Step 4:- calculation of value of Put at time t1

𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
Pu =
(1+𝑟)
𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

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 𝑃𝑟 𝑥 𝑃𝑑𝑢+(1−𝑝𝑟)𝑥𝑃𝑑 2 𝑃𝑟 𝑥 𝑃𝑑𝑢+(1−𝑝𝑟)𝑥𝑃𝑑 2
Pd = =
(1+𝑟) 𝑒 𝑟𝑐𝑥𝑡

Step 5 :- calculation of theoretical fair value of put:-

𝑃𝑟 𝑥 𝑃𝑢+(1−𝑝𝑟)𝑥𝑃𝑑
P= (1+𝑟)𝑜𝑟 𝑒 𝑟𝑐𝑥𝑡

(iii) If dividend is paid at time t1 (Adjustment of dividend in time t0 i.e.

re-combining Binomial tree):-
 Note: In this method dividend is adjusted in time t=0 i.e. stock
price minus follows the Binomial process present value of
dividend.

Step 1: setting up adjusted stock price path (Recombining Binomial tree

approach):

 Working note
𝐷1
S’0 = S0 –
(1+𝑟)𝑡
𝐷1
= S0 –
𝑒 𝑟𝑐 𝑥 𝑡
S’u = S’0 x u
S’d = S’0 x d

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Step 2: setting up put price path and calculation of intrinsic value of put at time t 2
:

Pu2 = Max (0, E - S’u2)

Pud = Max (0, E- S’ud)

Pd2 = Max (0, E - S’d2)

Step 3 : calculation of probability:-

(1+𝑟)𝑡 −𝑑
Pr =
𝑢−𝑑
𝑒 𝑟𝑐𝑥𝑡
=
𝑢−𝑑

Step 4:- calculation of value of put at time t1 :-

𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
Pu =
(1+𝑟)
𝑃𝑟𝑥𝑃𝑢2 +(1−𝑃𝑟)𝑥 𝑃𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
Pd = (1+𝑟)

𝑃𝑟 𝑥 𝑃𝑢𝑑+(1−𝑝𝑟)𝑥𝑃𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡

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Step 5:- calculation of theoretical fair value of put:-
𝑃𝑟 𝑥 𝑃𝑢+(1−𝑝𝑟)𝑥𝑃𝑑
P= (1+𝑟)𝑜𝑟 𝑒 𝑟𝑐𝑥𝑡