crystallizing of dividends for derivatives ...

  1. 5,823 Posts.
    Hmmm... We in Oz are familiar with the twice yearly discrete payment of dividends and from time to time the question arises as to how to deal with these with respect to FAIR VALUE or Derivatives (ETO/Warrants) ...

    Theoretically, no Option Pricing Model will do this, however, we must nevertheless accommodate the dividend payment into the Underlying valuation.

    As we know, the underlying has a tendency to rise towards the ex-div date and then drop in relation to the amount of dividend paid.

    Due to the LEVERAGE involved in relation to these movements in the Underlying, a way of smoothing derivative prices is required.

    Those with OPM's will require a method to incorporate these into their spreadsheets.

    In Oz, a relatively unsophisticated but simple way has been adopted which works with both BS and Binomial OPM's.

    The method requires the estimated dividend amount be deducted from the Underlying Price and applied at a point 45 days (calender) out from the Ex-Dividend Date.

    The spreadsheet OPM alters the Underlying Price Input by including another Cell with Dividend Value and would look like this ... e.g. (Underlying Price-Dividend). At the 45 day point, the estimated Dividend amount is entered into the Dividend Cell.

    The Implied Volatility is then recalculated which has the net effect of increasing this and in some cases quite dramatically ...

    Example: CBA has just gone 45 days/ex-div. The Warrant CBAWGN ... Imp/Vol 040103=7.5%. Following crystallization of dividend:060103=21.55% (Parity's approx=22.8%)

    At Ex-Dividend Date, our OPM is adjusted by reseting the amount in our Dividend Cell back to ZERO which has the affect of increasing Derivative FAIR VALUE but of course offset by the fall in the Underlying Price ...

    This smoothing is deliberate and for the most part works well.

    Sometimes, the fall in the Underlying is less (say where a stock is otherwise rallying strongly ...) than the Dividend amount and this represents a risk-free profit for Derivative traders.

    Cheers ...

    This is only my view ... read the red stuff.
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