Option Pricing And Momentum

When a stock pays a stochastic dividend, a negative correlation between the returns on the stock and the innovations to the dividend yield induces momentum in stock returns. This situation may arise if managers are reluctant to fully adjust dividends to changes in earnings. This paper studies the pricing of options in such a case, within a new model in which the dividend yield is an affine function of past stock performance. The model accommodates momentum in stock returns under complete markets and renders preference-free formulas for European options.