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Universal bad news principle and pricing of options on dividend-paying assets

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  • Svetlana Boyarchenko
  • Sergei Levendorskii

Abstract

We solve the pricing problem for perpetual American puts and calls on dividend-paying assets. The dependence of a dividend process on the underlying stochastic factor is fairly general: any non-decreasing function is admissible. The stochastic factor follows a Levy process. This specification allows us to consider assets that pay no dividends at all when the level of the underlying factor (say, the assets of the firm) is too low, and assets that pay dividends at a fixed rate when the underlying stochastic process remains in some range. Certain dividend processes exhibiting mean-reverting features can be modelled as appropriate increasing functions of Levy processes. The payoffs of both the American put and call options can be represented as the expected present value (EPV) of a certain stream of dividends, and we show that the option must be exercised the first time the EPV of this stream with the original process being replaced by the infimum process starting from the current level, becomes positive. Thus, the exercise threshold depends only on the record setting bad news. The results can be applied to the theory of real options as well; as one of possible applications, we consider the problem of incremental capital expansion.

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Bibliographic Info

Paper provided by arXiv.org in its series Papers with number cond-mat/0404108.

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Date of creation: Apr 2004
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Handle: RePEc:arx:papers:cond-mat/0404108

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Web page: http://arxiv.org/

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  1. Andrew B. Abel & Janice B. Eberly, . "The Effects of Irreversibility and Uncertainty on Capital Accumulation," Rodney L. White Center for Financial Research Working Papers 21-95, Wharton School Rodney L. White Center for Financial Research.
  2. Bianca Hilberink & L.C.G. Rogers, 2002. "Optimal capital structure and endogenous default," Finance and Stochastics, Springer, vol. 6(2), pages 237-263.
  3. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
  4. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  5. Peter Carr & Helyette Geman, 2002. "The Fine Structure of Asset Returns: An Empirical Investigation," The Journal of Business, University of Chicago Press, vol. 75(2), pages 305-332, April.
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Cited by:
  1. Svetlana Boyarchenko & Sergei Levendorskii, 2004. "Real options and the universal bad news principle," Finance 0405011, EconWPA.
  2. Flavia Barsotti, 2012. "Optimal Capital Structure with Endogenous Default and Volatility Risk," DiMaD Working Papers 2012-02, Dipartimento di Matematica per le Decisioni, Universita' degli Studi di Firenze.

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