The Fallacy of Fully Dividend-Protected Stock Options and Convertible Bonds

Full dividend protection via path-dependent re-striking has long been standard market practice for over-the-counter equity options. Recently, it has become a market standard for convertible bond issuances too. The author shows that the zero-dividend valuation approach commonly used by market practitioners is structurally biased and may induce a significant shortfall in protection against dividend payments. This article provides the theoretical setting to explain this bias in option pricing. It offers a new low-dimensional valuation approach to quantify the bias, which spares the re-structuring of the original security on a path dependent basis and improves the tractability of more exotic securities such as convertible bonds.