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Stock option contract adjustments: The case of special dividends

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  • Barraclough, Kathryn
  • Stoll, Hans R.
  • Whaley, Robert E.
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    Abstract

    The terms of stock option contracts are adjusted in the event of unexpected corporate actions, and the nature of the adjustments may result in windfall gains or losses to open option positions. This paper evaluates the fairness of the two different procedures used for special cash dividends. We show that, while neither procedure is technically correct, the absolute adjustment used in the U.S. and Canada minimizes the windfall change in option value when the dividend is announced. In addition, the proportional adjustment used in Australia and Europe depends on stock price and is therefore vulnerable to temporary aberrations in the stock market.

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    File URL: http://www.sciencedirect.com/science/article/pii/S1386418111000474
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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Markets.

    Volume (Year): 15 (2012)
    Issue (Month): 2 ()
    Pages: 233-257

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    Handle: RePEc:eee:finmar:v:15:y:2012:i:2:p:233-257

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    Web page: http://www.elsevier.com/locate/finmar

    Related research

    Keywords: Stock option; Special dividend; Contract adjustment; Displaced diffusion process; Nested binomial lattices;

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    References

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    1. Elton, Edwin J & Gruber, Martin J, 1970. "Marginal Stockholder Tax Rates and the Clientele Effect," The Review of Economics and Statistics, MIT Press, vol. 52(1), pages 68-74, February.
    2. John R. Graham & Roni Michaely & Michael R. Roberts, 2003. "Do Price Discreteness and Transactions Costs Affect Stock Returns? Comparing Ex-Dividend Pricing before and after Decimalization," Journal of Finance, American Finance Association, vol. 58(6), pages 2611-2636, December.
    3. Rubinstein, Mark, 1983. " Displaced Diffusion Option Pricing," Journal of Finance, American Finance Association, vol. 38(1), pages 213-17, March.
    4. Fleming, Jeff & Whaley, Robert E, 1994. " The Value of Wildcard Options," Journal of Finance, American Finance Association, vol. 49(1), pages 215-36, March.
    5. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
    6. David Durand & Alan M. May, 1960. "The Ex‐Dividend Behavior Of American Telephone And Telegraph Stock," Journal of Finance, American Finance Association, vol. 15(1), pages 19-31, 03.
    7. Whaley, Robert E., 1981. "On the valuation of American call options on stocks with known dividends," Journal of Financial Economics, Elsevier, vol. 9(2), pages 207-211, June.
    8. Barone-Adesi, Giovanni & Whaley, Robert E., 1986. "The valuation of American call options and the expected ex-dividend stock price decline," Journal of Financial Economics, Elsevier, vol. 17(1), pages 91-111, September.
    9. James A. Campbell & William Beranek, 1955. "Stock Price Behavior On Ex‐Dividend Dates," Journal of Finance, American Finance Association, vol. 10(4), pages 425-429, December.
    10. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    11. Roll, Richard, 1977. "An analytic valuation formula for unprotected American call options on stocks with known dividends," Journal of Financial Economics, Elsevier, vol. 5(2), pages 251-258, November.
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