Research

D. Hait: Dividend Forecasts, Option Pricing Models, and Implied Volatility Calculations: Why Simpler is Better

March 1, 2001

For the purposes of calculating option prices or implied volatilities, the use of a dividend forecasting model based on projected actual dividend growth rates can lead to an option model which is internally inconsistent. In contrast, the use of a model based on constant dividend yields is not only consistent, but also easier to implement. Regardless of the method of handling future dividend payments, any associated errors in the forecast dividend rate will in general result have only a small impact on calculated option implied volatilities, even for long-dated options.