8. Which of the following statements correctly describes how dividends affect the exercise probability of an American option?

A. The probability of exercising a call option is inversely related to the dividend yield, while the probability of exercising a put option is positively related to the dividend yield.

B. The probability of exercising a call option is positively related to the size of the dividend, while an American put option is normally exercised irrespective of the size of the dividend.

C. A large expected dividend increases the probability of exercise of a put option and reduces the probability of exercise of a call option.

D. A large expected dividend increases the probability of exercise of a call option and reduces the probability of exercise of a put option.

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A is Incorrect. Not exercising Call Option against high dividend amount will result in dividend loss to option holder.  He is more prompted to exercise call option to get high dividend. 

B is Incorrect. If Put Option holder exercises his option and sell the underlying security inspite of it carrying high dividend amount, he will loose out on dividend.  Hence, a very high Dividend Amount prompts Put option holder to hold the option and not to exercise it.

C is Incorrect. High dividend amount will induce put option holder not to sell off underlying and induce call option holder to get the security and dividend also.  Hence, high dividend amount will increase probability of exercising Call Option and not Put Option.

D is Correct. High dividend amount will induce put option holder not to sell off underlying an induce call option holder to get the security and dividend also. 

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Type of Question : Market Risk