Abstract
A formula is derived in discrete time for pricing options when the underlying stock has a stochastic dividend yield. The result implies that regarding the dividend yield as certain when it is not results in misestimation of the variance of the underlying stock. Comparative statics indicate that this adjustment could diminish a bias of the Black‐Scholes model. This model systematically underprices deep‐out‐of‐the‐money options. A numerical example demonstrates that this stochastic adjustment may be more important for longer‐lived options and warrants.
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