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While many systems like to treat dividends as a continuous yield when pricing equity options, it works quite poorly for short-dated options.

In the short run, deterministic dividends are clearly the way to go, since the upcoming dividend is usually known with fairly high precision. In the medium term, we may start to think of those dividends as being linked to the stock price, but still want to treat them discretely so as to get early exercise dates right. In the long term, tracking all those discrete dividends becomes a pain and it feels nicest to go back to a yield.

Advanced option pricing frameworks allow for mixtures of these 3 treatments. What are some good ways of selecting a reasonable mixture of dividend treatments in any given circumstance?

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1 Answer 1

Time to expiration is what should guide the choice.

A tractable approach is to make the distinction between discrete and yield at the LEAP boundary (or simpler options with expiration more than 1yr into the future).
When the options are long dated, like LEAPs for example, then the simplicity of the yield approach is usually 'good enough'.

It usually makes sense for to ONLY use the the discrete dividend approach for options near expiration.

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