Often dividend payments are regular and predictable. With many companies,the dividend remains constant quarter after quarter. Some corporations have a track record of incrementally increasing their dividends every year.Some companies pay dividends in a very irregular fashion, by paying special dividends that are often announced as a surprise to investors.
In a truly capitalist society, there are no restrictions and no rules on when, whether, or how corporations pay dividends to their shareholders. Unpredictability of dividends, though, can create problems in options valuation.When a company has a constant, reasonably predictable dividend, there is not a lot of guesswork. Take Exelon Corp.
(EXC). From November 2008 to the time of this writing, Exelon has paid a regular quarterly dividend of $0.525. During that period, a trader has needed simply to enter 0.525 into the pricing calculator for all expected future dividends to generate the theoretical value. Based on recent past performance, the trader could feel confident that the computed analytics were reasonably accurate.
If the trader believed the company would continue its current dividend policy, there would be little options-related dividend risk—unless things changed.When there is uncertainty about when future dividends will be paid in what amounts, the level of dividend-related risk begins to increase.
Let’s examine an interesting case study:General Electric (GE).For a long time, GE was a company that has had a history of increasing its dividends at fairly regular intervals. In fact, there was more than a 30-year stretch in which GE increased its dividend every year. During most of the first decade of the 2000s, increases in GE’s dividend payments were around one to six cents and tended to occur toward the end of December, after December expiration.
The dividends were paid four times per year but not exactly quarterly. For several years, the ex-dates were in February, June, September, and December. Option traders trading GE options had a pretty easy time estimating their future dividend streams, and consequently evaded valuation problems that could result from using wrong dividend data.
Traders would simply adjust the dividend data in the model to match their expectations for predictably increasing future dividends in order to achieve an accurate theoretical value. Let’s look back at GE to see how a trader might have done this.The following shows dividend-history data for GE. At the end of 2006, GE raised its dividend from $0.25 to $0.28.
A trader trading GE options at the beginning of 2007 would have logically anticipated the next increase to occur again in the following December Dividends and Option Pricing 153 unless there was reason to believe otherwise. Options expiring before this anticipated next dividend increase would have the $0.28 dividend priced into their values.
Options expiring after December 2007 would have a higher dividend priced into them—possibly an additional three cents to 0.31 (which indeed it was). Calls would be adversely affected by this increase, and puts would be favorably affected. A typical trader would have anticipated those changes. The dividend data a trader pricing GE options would have entered into the model in January 2007 would have looked something like this.
The trader would have entered the anticipated future dividend amount in conjunction with the anticipated ex-dividend date. This trader projection goes out to February 2008, which would aid in valuing options expiring in 2007 as well as the 2008 LEAPS. Because the declaration dates had yet to occur, one could not know with certainty when the dividends would be announced or in what amount.
Certainly, there would be some estimation involved for both the dates and the amount. But traders would probably get it pretty close—close enough.Then, something particularly interesting happened. Instead of raising the dividend going into December 2008 as would be a normal pattern, GE kept it the same. As shown, the 12/24/08 ex-dated dividend remained $0.31.
The dividend stayed at $0.31 until the June 2009 dividend, which held another jolt for traders pricing options. Around this time, GE’s stock price had taken a beating. It fell from around $42 a share in the fall of 2007 ultimately to about $6 in March 2009. GE had its first dividend cut in more than three decades.
The dividend with the ex-date of 06/18/09 was $0.10.Though the company gave warnings in advance, the drastic dividend change had a significant impact on option prices. Call prices were helped by the dividend cut (or anticipated dividend cut) and put prices were hurt.The break in the pattern didn’t stop there.