This paper derives optimal perfect hedging portfolios in the presence of tr
ansaction costs within the binomial model of stock returns, for a market ma
ker that establishes bid and ask prices for American call options on stocks
paying dividends prior to expiration. It is shown that, while the option h
older's optimal exercise policy at the ex-dividend date varies according to
the stock price, there are intervals of values for such a price where the
optimal policy would depend on the holder's preferences. Nonetheless, the p
erfect hedging assumption still allows the derivation of optimal hedging po
rtfolios for both long and short positions of a market maker on the option.
(C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: G1
3.