Analytical Approximations of American Call Options with Discrete Dividends

Abstract

In this study, we assume that stock prices follow piecewise geometric Brownian motion, a variant of geometric Brownian motion except the ex-dividend date, and find pricing formulas of American call options. While piecewise geometric Brownian motion can effectively incorporate discrete dividends into stock prices without losing consistency, the process results in the lack of closed-form solutions for option prices. We aim to resolve this by providing analytical approximation formulas for American call option prices under this process. Our work differs from other studies using the same assumption in at least three respects. First, we investigate the analytical approximations of American call options and examine European call options as a special case, while most analytical approximations in the literature cover only European options. Second, we provide both the upper and the lower bounds of option prices. Third, our solutions are equal to the exact price when the size of the dividend is proportional to the stock price, while binomial tree results never match the exact option price in any circumstance. The numerical analysis therefore demonstrates the efficiency of our method. Especially, the lower bound formula is accurate, and it can be further improved by considering second order approximations although it requires more computing time.