But option holders do not participate fully in the downside risk of a stock. If the option is out of the money at the end of its term, it is unimportant to the option holder how far out of the money it is. The example continues with a 10-year option and demonstrates that the relative effect of mismeasuring volatility is less for options with longer terms to expiration. The proportional error in the estimated value of an option is smaller than the proportional error in projected volatility that caused it. Moreover, the importance of an error in the estimate of volatility diminishes with longer-lived options.
Dividend yield is defined as the annual dividend payout divided by the average price of the stock.
Exhibit 2 shoves that an option's value decreases as dividend yield increases. The reason is that option holders do not receive dividends on their options. They only benefit from the stock's appreciation. If more of the total return on the stock takes the form of current dividends, less is left over for appreciation. The relative effect of mismeasuring dividend yield grows larger with increases in the life of the option.