Dividends, Interest Rates, and Their Effect on Stock Options

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Dividends, Interest Rates, and Their Effect on Stock Options

While the math underpinning option pricing models may seem difficult, the basic ideas are straightforward. The price of the underlying stock, volatility, time, dividends, and interest rates are the factors utilized to determine the fair value of a stock option. The first three demand the most attention since they have the greatest impact on option pricing. However, it is also critical to understand how dividends and interest rates impact the price of a stock option, particularly when selecting whether to exercise options.

Key Takeaways

  • Dividends and interest rates are both components of options pricing models, and they have differing effects on calls and puts.
  • Because call options have a positive rho, a rise in interest rates will raise their value, whereas a decrease in interest rates would decrease the value of puts, which have a negative rho.
  • Because dividends are paid to shareholders but not to option holders, when a stock goes ex-dividend, call prices fall and put prices increase.

Black-Scholes Doesn’t Account for Early OptionsExercise

The first option pricing model, the Black-Scholes model, was created to assess European options that do not allow for early exercise. As a result, Black and Scholes never discussed whether to exercise an option early or how much the right to execute an option early is worth. The ability to exercise an option at any time should theory make an Americanoption more valuable than a comparable Europeanoption, however there is no difference in how they are traded in reality.

To appropriately price American options, many models were devised. The majority of them are modified versions of the Black-Scholes model, with dividends and the potential of early exercise factored in. To comprehend the impact that these changes may make, you must first understand when an option should be exercised early.

In a nutshell, an option should be exercised as soon as its theoretical value reaches parity and its delta equals 100. This may seem difficult, but when we analyze the impact of interest rates and dividends on option pricing, we will give an example to demonstrate when this happens. First, let’s look at how interest rates affect option pricing and how they might influence whether you should exercise a put option early.

The Effects of Interest Rates

The sensitivity of an option’s price to changes in interest rates is measured by Rho. Call premiums will rise as interest rates rise, but put prices will fall. As a result, calls have a positive rho and puts have a negative rho.

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To understand why you should consider interest rates when comparing an option position to merely owning the stock. Because buying a call option is substantially cheaper than buying 100 shares of stock, the call buyer is ready to pay extra for the option when rates are relatively high because they can invest the difference in capital needed between the two positions.

Interest rates have a minor influence on option prices when interest rates are progressively declining to a point where the federal funds’ objective is about 1.0% and short-term interest rates accessible to people are at 0.75% to 2.0% (as in late 2003). All of the finest option analysis models calculate interest rates using a risk-free interest rate, such as US Treasury rates.

The key aspect in deciding whether to execute a put option early is interest rates. When the interest that may be generated on the profits from the selling of the stock at the strike price is significant enough, a stock put option becomes an early exercise candidate. Determining when this occurs is tricky since everyone has different opportunity costs, but it does suggest that early execution of a stock put option might be optimum at any moment, providing the interest earned gets sufficiently high.

The Effects of Dividends

It is easy to determine how dividends influence early exercise. Cash dividends influence option pricing by influencing the underlying stock price. High cash dividends indicate lower call prices and higher put premiums since the stock price is likely to fall by the amount of the dividend on the ex-dividend date.

While the stock price is normally adjusted once by the dividend amount, option prices anticipate dividends to be paid in the weeks and months before they are declared. When charting a position, the dividends paid should be included when determining the notional price of an option and forecasting your potential gain and loss. This is also true for stock indexes. When determining the fair value of an index option, the dividends paid by all stocks in that index (adjusted for each stock’s weight in the index) should be included.

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Dividends are important in deciding whether it is best to execute a stock call option early, thus both buyers and sellers of call options should think about them. Owners of call options may exercise in-the-money options early to obtain the cash dividend if they possess the shares as of the ex-dividend date. Early execution of a call option makes sense only if the stock is likely to pay a dividend before the expiry date.

Traditionally, the option would be best exercised the day before the stock’s ex-dividend date. However, changes in dividend tax legislation imply that the individual exercising the call may have to wait two days before owning the shares for 60 days to take benefit of the reduced dividend tax. Let’s look at an example to discover why this is the case (ignoring the tax implications since it changes the timing only).

Exercising the Call Option Example

Assume you have a call option with a strike price of 90 that expires in two weeks. The stock is presently trading at $100, and a $2 dividend is scheduled to be paid tomorrow. The call option is very close to expiration and should have a fair value of 10 and a delta of 1. As a result, the option shares many of the same characteristics as the stock. There are three options available to you:

  1. Do nothing (hold the option),
  2. Exercise the option early, or
  3. Buy 100 shares of stock and sell the option.

Which of these options is the best? If you keep the choice, your delta position will be maintained. However, after deducting the $2 dividend, the stock will begin ex-dividend tomorrow at 98. Because the option is at parity, it will open at the new parity price of 8, and you will lose two points ($200) on the trade.

You lock in the 10 points of value if you execute the option early. You lose $2 per share when the stock goes ex-dividend, but you also get the $2 dividend since you now own the shares.

Because the $2 loss in stock price is mitigated by the $2 dividend received, exercising the option is preferable than retaining it. This is not because you made more money, but because you avoided a two-point loss. To break even, you must exercise the option early.

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What about the third alternative, which is to sell the option and purchase stock? This seems to be fairly similar to early exercise in that you are replacing the option with shares in both circumstances. Your selection will be influenced by the cost of the option. In this example, we said that the option is trading at parity (10), which means that there is no difference between exercising the option early or selling the option and purchasing the stock.

However, options are seldom traded precisely at parity. Assume your 90 call option is worth more than parity, say $11. If you sell the option and buy the shares, you would still get the $2 dividend and possess a stock worth $98, but you will also earn an extra $1 that you would not have received if you had executed the call.

Alternatively, if the option is trading below parity, say $9, you should execute the option as soon as possible. This assures that you get 10 points (rather than only 9 if you sold the call) plus the $2 dividend. The only time it makes sense to execute a call option early is if the option is trading at or below parity and the stock is scheduled to go ex-dividend the following day.

The Bottom Line

Although interest rates and dividends are not the key variables influencing option prices, options traders should be aware of their implications. In reality, the main disadvantage of many of the existing option analysis tools is that they employ a simplistic Black Scholes model and neglect interest rates and dividends. The consequence of not correcting for early exercise may be significant, as it might lead an option to seem undervalued by up to 15%.

Remember that while competing in the options market against other investors and professional market makers, you should utilize the most precise instruments available.

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