On the Valuation of Equity Options with Dividend-Protection Features

Abstract

This note describes the various techniques used to protect the writer of an equity option against the risk of dividend uncertainty. We first explicitly formulate the PnL tracking error in presence of dividend misspecification. We then describe various ways to offset the dividend risk: for vanilla options practitioners usually adjust the strike and notional across an ex-div date. We justify this approximation. We then introduce an alternative way that does not require a change in the strike and that involves an extra exchange of cash flow across the ex-div date.