Step1:Ifthevarianceinln(stockprices)hasbeenestimated
for the Black-Scholes, convert these into inputs for the
binomial:
whereuanddaretheupanddownmovementsperunitof
timeforthebinomial,Tisthelifeoftheoption,andmisthe
number of periods within that lifetime.
Step2:Specifytheperiodinwhichthedividendswillbepaid
and make the assumption that the price will drop by the
amount of the dividend in that period.
Step3:Valuethecallateachnodeofthetree,allowingfor
thepossibilityofearlyexercisejustbeforeex-dividenddates.
Therewillbeearlyexerciseiftheremainingtimepremiumon
theoptionislessthantheexpecteddropinoptionvalueasa
consequence of the dividend payment.
Step4:Valuethecallattime0,usingthestandardbinomial
approach.
Impact of Exercise on Value of Underlying Asset
The Black-Scholes model isbased onthe assumption that
exercising an option does not affect the value of the
underlying asset. This may be true for listed options on
stocks, but it is not true for some types of options. For
instance, the exercise of warrants increases thenumber of