Value of European Call on Dividend paying Stock/ Dividend &

Theoretical Fair Value of European Call

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.

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 Where,

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

dy = percentage of dividend

D = Amount of dividend

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

Cu2 = Max (o, S’u2 – E)

Cud = Max (o, S’ud – E)

Cd2 = Max (0, S’d2 – E)

o Step 3 : calculation of probability:-

(1+𝑟)𝑡 −𝑑
Pr =
𝑢−𝑑
𝑒 𝑟𝑐𝑥𝑡
=
𝑢−𝑑

2
o Step 4 :- calculation of value of call at time t1 :-

𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑

Cu =
(1+𝑟)
𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
Cd = (1+𝑟)

𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡

o Step 5 :- calculation of theoretical fair value of call:-

𝑃𝑟 𝑥 𝐶𝑢+(1−𝑝𝑟)𝑥𝐶𝑑
C= (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

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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

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

Cu2 = Max (o, S’u2 – E)

Cud = Max (o, S’ud – E)

Cd2 = Max (0, S’d2 – E)

o Step 3 : calculation of probability:-

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

𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑

Cu =
(1+𝑟)
𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

4
 𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
Cd = (1+𝑟)

𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡

o Step 5 :- calculation of theoretical fair value of call:-

𝑃𝑟 𝑥 𝐶𝑢+(1−𝑝𝑟)𝑥𝐶𝑑
C= (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):

o 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

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 S’ud = S’u x d
S’du = S’d xu
S’d2 = S’d xd

o Step 2 : setting up call price path(non-recombining tree) and calculation of

intrinsic value of call at time t2 :-

Cu2 = Max (o, S’u2 – E)

Cud = Max (o, S’ud – E)

Cdu = Max (o, S’du– E)

Cd2 = Max (0, S’d2 – E)

o Step 3 : calculation of probability:-

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

𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑

Cu =
(1+𝑟)
𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

6
 𝑃𝑟 𝑥 𝐶𝑑𝑢+(1−𝑝𝑟)𝑥𝐶𝑑 2 𝑃𝑟 𝑥 𝐶𝑑𝑢+(1−𝑝𝑟)𝑥𝐶𝑑 2
Cd = =
(1+𝑟) 𝑒 𝑟𝑐𝑥𝑡

o Step 5 :- calculation of theoretical fair value of call:-

𝑃𝑟 𝑥 𝐶𝑢+(1−𝑝𝑟)𝑥𝐶𝑑
C= (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 present value of dividend.
o 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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o Step 2 : setting up call price path and calculation of intrinsic value of call at
time t 2 :

Cu2 = Max (o, S’u2 – E)

Cud = Max (o, S’ud – E)

Cd2 = Max (0, S’d2 – E)

o Step 3 : calculation of probability:-

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

𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑

Cu =
(1+𝑟)
𝑃𝑟𝑥𝐶𝑢2 +(1−𝑃𝑟)𝑥 𝐶𝑢𝑑
or =
𝑒 𝑟𝑐𝑥𝑡

𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
Cd = (1+𝑟)

𝑃𝑟 𝑥 𝐶𝑢𝑑+(1−𝑝𝑟)𝑥𝐶𝑑 2
=
𝑒 𝑟𝑐𝑥𝑡

o Step 5 :- calculation of theoretical fair value of call:-

𝑃𝑟 𝑥 𝐶𝑢+(1−𝑝𝑟)𝑥𝐶𝑑
C= (1+𝑟)𝑜𝑟 𝑒 𝑟𝑐𝑥𝑡