Dividend Risk

Stefan Kruchen , Paolo Vanini

Zurich Cantonal Bank, Z urich University of Zurich, Zurich and Swiss Finance Institute (This version: July 28, 2008)

Corresponding author: Paolo Vanini, paolo.vanini@isb.unizh.ch. Acknowledgments. We received useful comments from Philipp Halbherr, Markus Leippold, Rajna Gibson. P. Vanini gratefully acknowledges support from the National Center of Competence in Research Financial Valuation and Risk Management (NCCR-FINRISK) and the Swiss Finance Institute Foundation.

Electronic copy available at: http://ssrn.com/abstract=1184858

Abstract Comparing realized dividends with dividend forecasts, we propose to describe dividend risk by a truncated t-distribution. We then investigate the impact of dividend uncertainty on European and American option prices. We nd that the impact of dividend uncertainty on option prices is negligible for short term options. Dividend timing risk is only relevant in case of European options, if the ex-dividend date might be postponed to occur after the options maturity. But the impact of dividend risk on long dated option prices is not negligible since analysts forecasts scatter much more for several years of dividend forecast. We nally propose a modication of Lintners (1956) partial adjustment model for dividends which improves prediction of dividend cuts.

Keywords: Dividend Risk, Option Pricing, Forecasting. JEL Classication: G1, G13, G14

Electronic copy available at: http://ssrn.com/abstract=1184858

Introduction

Common derivative pricing theory assumes that dividends are known. Typically, new dividends are assumed to equal former ones. In reality, however, this assumption might be too strong. Dividends not necessarily follow the historically observed pattern. They can be distributed with unforeseen deviations, both in size and timing. This is a challenge for derivative traders, which have to price and hedge derivative contracts using estimates of future dividends. Geske (1978) is the rst to account for dividend uncertainty in option pricing. Assuming a stochastic dividend yield, he derives European option prices in terms of an adjusted BlackScholes formula. Chance, Kumar, and Rich (2002) consider stochastic discrete dividends. They circumvent the problem of specifying dividend uncertainty explicitly by assuming that the present value of all future dividends is observable and tradable in a forward contract. The Black-Scholes formula is then used to price European options. Broadie et al. (2000) characterize the prices of American options, when the underlying asset has stochastic volatility and uncertain dividend yield. Using non-parametric techniques, they nd empirically that American call prices and early exercise decisions are driven by both, volatility and dividend risk. Although this list of articles is not complete, research in this eld is limited. Most academics apparently take for granted that dividend risk has a minor impact on option prices. Chance, Kumar and Rich (2000) support this view. They compare index option prices based on ex-post realized dividend information with contracts which are valued using ex-ante formed dividend forecasts. They nd that index option valuation based on forecasted dividends does not lead to biased pricing. While the assumption of a known dividend appears to be negligible in case of index option valuations, it is problematic for single stock options. Dividend uncertainty is balanced out, when considering aggregated dividends as in case of indices. Single stock options are aected by an individual dividend only. Thus, a change in the latter has a signicant impact on the options price. We rst investigate the impact of unforeseen changes of the discrete cash dividend on sin-

gle stock option prices. We work under the hypothesis of stochastic discrete cash dividends. We assume that either timing or magnitude of the dividend is uncertain. Since options on major stocks are liquidly available in the market, we propose a methodology to extract information on dividend uncertainty from observable option prices. We then outline a dividend model to improve dividend forecasts, which is able to predict dividend cuts based on shortfall probability of the stock price. The model is a modication of the partial adjustment model proposed by Lintner (1956). On the basis of this enhanced dividend model, we propose an early warning system for dividend cuts. In Section 2, we provide empirical evidence for uncertainty about dividends. Section 3 considers option pricing under dividend uncertainty. We calculate option prices and analyze the impact of the dividends stochastic nature. In Section 4 we propose an alternative dividend model which extends Lintners model (1956). Section 5 concludes.

Empirical evidence for dividend uncertainty

Practitioners pricing derivative contracts require information about future dividend payments. Estimates of dividends used in practice are based on analysts forecasts. The quality of these forecasts allows us to gain knowledge about the stochastic nature of dividends. The more uncertain dividends are for the analysts, the more signicant is the deviation between realized and forecasted dividends. We dene dividend risk as the uncertainty about the deviation of the ex-post realized dividend payment from the ex-ante formed forecast. We perform a simple empirical analysis to measure dividend risk. For most traded stocks a range of dividend forecasts is observable in the market. We attribute this uncertainty to dierent skills of individual analysts. This risk induced by analysts skills is not considered in our denition of dividend risk. For that reason, we consider the average analysts estimate as our view on the rms future dividend. We analyze the deviations of the ex-ante formed average dividend forecasts from the ex-post realized dividends to nd evidence for uncertainty about future dividends. We base the analysis on average dividend forecasts provided by Datastream for three

samples. A sample of 39 stocks indexed in the Eurostoxx 50 stock index, 97 stocks indexed in the DAX 100 and 26 constituent stocks of the SMI from 1994 to 2006. While dividends are considered to be paid on a yearly basis in our analysis, dividend forecasts are formed much more frequently throughout time. The data set consists of dividend forecasts formed on a monthly basis. Hence, the time between the announcements until the dividend payment is considered too for measuring dividend risk. To capture this time to dividend payment eect, we analyze the resulting deviations at dierent time horizons until the ex-dividend date. We empirically measure dividend risk for a 6 months, 1 year and 2 years time to dividend payment. Since cash dividends vary in size across companies, we scale the deviations by the average of the distributed dividend for each stock. The scaled deviations are aggregated over all stocks to obtain a sample of signicant size. Figures 1 provide the histogram of aggregated scaled deviations formed at the respective time to dividend payment for each of the considered data sets. For the 6 months period we observe highly leptokurtic graphs which are centered at zero. Hence, on average forecasts equal realized dividends in the short-term. But the histograms of the short-term dividend forecast also provide evidence for fat tails. While most deviations are of small size, there is a signicant number of forecasts which shows large deviations. The probability mass in the right tail indicates unexpected dividend cuts or large reductions in the realized dividend compared to the forecasts. The left tail can be attributed to booming rms, which pay much higher than expected dividends, or to recovering rms, which continue to pay dividends after a series of cuts. We further observe that for an increasing time to dividend payment the center of the historical distribution shifts to the right and the dispersion of the 1 year and 2 year deviations increases. Compared to the short-term the tails of the histograms become lighter in the long run. The right shift in the center shows that dividend forecasts tend to underestimate the realized dividend. In other words, long-term dividend forecasts are formed conservatively. Growing volatility indicates increased uncertainty about the dividend payment. To describe these patterns in terms of a probability distribution we t a t-distribution with degrees of freedom to the data sets. Figures 1 show the tted density function of

Figure 1: Histogram of deviations of forecasted dividends from realized dividends with tted t-distribution

Figure 1: Histogram of deviations of forecasted dividends from realized dividends with tted t-distribution for the sample of ESTOXX50 stocks. Figure 2: Histogram of deviations of forecasted dividends from realized dividends with tted t-distribution for the sample of DAX100 stocks. Figure 3: Histogram of deviations of forecasted dividends from realized dividends with tted t-distribution for the sample of SMI stocks.

the t-distribution. This distribution is exible enough to capture the highly leptokurtic data with evidence for fat tails in the short-run and furthermore to t the more dispersed data in the long-term. As a comparison we also t a normal distribution to the same data. Table 1 summarizes these results. The tted normal distribution does neither explain the leptokurtic feature, nor the outliers in the tail. But the t-distribution can explain the high probability mass for small deviations from realized dividends and also allows for larger deviations implying bad forecasts. The Kolmogorov-Smirnov test cannot reject the hypothesis that the data is t-distributed with the given parameters at the 5% signicance level. The empirical results indicate that dividend risk, characterized as deviations of realized 6

Table 1: Parameter estimates for the normal and t-distribution Parameter Normal distribution Estimate Std. Err. -0.03 0.04 0.57 0.03 t-distribution Estimate Std. Err. 0.01 0.01 0.16 0.02 1.32 0.19

dividends from available forecasts, can be satisfactory described using a t-distribution. All parameters of the distribution are a function of time increasing with time to dividend payment. Cross comparison of the three data sets suggests that dividend forecasts for DAX or Eurostoxx constituent stocks are more ecient than dividend forecasts for SMI indexed stocks. The shift in the mean is less pronounced for the former two data sets. The level of uncertainty is similar for DAX and Eurostoxx data, while slightly higher for the Swiss data. Fat tails remain emphasized in the DAX data set. The empirical results indicate that dividend risk, characterized as deviations of realized dividends from available forecasts, can be described in terms of a t-distribution centered at zero with degrees of freedom between one and two. The time to the ex-dividend date eect is negligible according to the considered data set. Cross comparison of the three data sets suggests that dividend forecasts for DAX or Eurostoxx constituent stocks are more ecient than dividend forecasts for SMI indexed stocks. The shift in the mean is less pronounced for the former two data sets. The level of uncertainty is similar for DAX and Eurostoxx data, while slightly higher for the Swiss data. Fat tails remain emphasized in the DAX data set.

Option Prices under Dividend Uncertainty

We investigate the impact of dividend risk on option prices. We relax the assumption of known dividends and assume that we only have an expectation about the next dividend. Geske (1978) is the rst to discuss the eect of stochastic dividends in option pricing. He notes that regarding the dividend yield as certain in cases where it is not, results in misestimation

of the variance of the underlying stock, and thus leads to mispricing of option contracts. An analytical solution for the case of a discrete stochastic dividend yield is given in form of an adjusted Black-Scholes formula.

3.1

Modelling option prices under uncertain dividends

Since discrete cash dividends are only paid at a few instants in time during the life time of an option, we do not model dividends by a stochastic process over time. To capture uncertainty, dividends are assumed to follow a specic probability distribution. We allow for uncertainty about both dividend parameters, size D and timing tD . We denote the joint dividend distribution function by FD for the parameter vector D = {D, tD } on the domain [0, S ] [t, ). Dividends cannot exceed the value of the stock price and are restricted to be positive. The the ex-dividend date tD is only bound by the current time t. In the previous section, the option prices were determined conditional on the knowledge of D and tD . Generally, the form of American and European contracts discussed can be represented by V (S, K, r, T, |D). The unconditional option price under the assumption of an uncertain dividend is given by V (S, K, r, T, ) = E Q V (S, K, r, T, |D) =
D

V (S, K, r, T, , D)dFD .

(1)

We describe uncertainty for either parameter by specifying a parametric distribution function. In the empirical analysis in the beginning of this section, we found evidence for the assumption that uncertainty about the size of the dividend can be described by a t-distribution with degrees of freedom between one and two. In this setup, we can explain the high probability mass for small deviations from realized dividends, but also allow for larger deviations implying bad forecasts. If we want to give less emphasis on the empirically observed tails, we can alternatively describe dividend risk by a normal distribution. We choose the same mean and volatility parameters as in case of the t-distribution. For the uncertainty about the timing of the dividend payment we do not have empirical results. We believe that changes in the

ex-dividend date are of smaller nature and mostly due to operational reasons. Postponing dividends for longer time periods is considered as a dividend cut for the respective year. We assume a normal distribution to model uncertainty about the timing. Since the normal and the t-distribution are dened on the domain R, we have to restrict the parameter space to the above dened domains for D and tD . We truncate the distribution functions at the boundaries of the domains of D. In the remainder of this section, we only deal with truncated distribution functions1 . We investigate the impact of both dividend dimensions, namely size and timing, separately, using option pricing formula (1). The conditional option price V (|D) is given by the integral expressions derived by Haug et al. (2003) for European and American calls, respectively. We impose the discussed distribution functions of the parameters D and tD and numerically solve the expression. This sheds light on the quantitative eect of uncertain discrete cash dividends on option prices.

3.2

Uncertainty about dividend size D

In the rst analysis, we assume that only the dividend amount D is random, whereas the ex-dividend date tD is known with certainty. Dividends follow the law of a truncated tdistribution. We provide comparable results for the case of normally distributed dividend risk. Figure 2 shows the relative deviations of option prices under uncertainty from prices assuming a deterministic dividend2 . We note that when the normal distribution is used to model dividend risk, this results in slightly higher option prices than for deterministic dividends3 . The eect is strongest for out-of-the-money options. We observe similar eects for American and European options. For t-distributed dividend risk, European option prices turn out to be lower than the comparable deterministic dividend prices. An explanation provides the asymmetry of the
1 The truncated normal and t distribution functions are denoted by Ntrunc (, , c0 , c1 ) and ttrunc (, , , c0 , c1 ), respectively. The parameters c0 and c1 specify the points of truncation. 2 Table ?? in Appendix ?? provides the numerical values of the option prices. 3 This observation is Jensens inequality eect, since option prices are convex with respect to dividend size D.

Figure 2: Deviations of option prices for dividend paying stocks under uncertainty about D from deterministic dividend option prices
European Call t =0.05
D

American Call t =0.05

D

Deviation (%)

0.5 0 0.5 1 80 90 100 110 120 European Call tD=0.5

2 1 0 1 80 0.5 90 100 110 American Call tD=0.5 120

Deviation (%)

0.5 0 0.5 80 0.5 0 0.5 80

90 100 110 120 European Call t =0.95

D

0 80 0.1 0.05 0 80

90 100 110 120 American Call t =0.95

D

Deviation (%)

90

100 Strike

110

120

90

100 Strike

110

120

The gures show deviations for option prices under normally distributed dividend risk (solid line) and tdistributed dividend risk (dotted line). The option prices are calculated for S0 = 100, T = 1, r = 0.05, = 0.3, and D Ntrunc (10, 1, 0, S0 ) or D ttrunc (10, 1, 1.5, 0, S0 ).

considered distribution function. While the t-distribution function itself is symmetric around its mean, we truncated it to prevent negative dividends. This induces an asymmetric distribution function4 . The longer positive tail, explaining large dividends, leads to lower option prices with non-zero probability mass. This outweighs the eect of higher option prices due to lower dividends. Contrary, the truncated normal distribution is almost symmetric, since the truncation occurs far in the tail. American option prices show a dierent eect than their European counterparts. We note that t-distributed dividend risk leads to higher option prices for ex-dividend dates tD = 0.5 and tD = 0.95. Contrary to European options on dividend paying stocks, the price of an American call is bound from below by the value of an European call maturing right before the ex-dividend date. The later the dividend payment occurs, the lower is its impact on the option price. Higher option prices for low dividends outweigh the eect of larger dividends.
Contrary, the truncation of the normal distribution does merely eect its symmetry, since the truncation occurs far in the tail.
4

10

Figure 3: Deviations of option prices for dividend paying stocks under uncertainty about tD from deterministic dividend option prices
t =0.05
D

t =0.5
D

1 Deviation (%) 0.8 0.6

0.3 0.2 0.1

0.4 0.2 0 80 90 100 tD=0.95 0 10 5 0 5 80 110 120 0 0.1 80

90
D

100 t =0.95*

110

120

Deviation (%)

0.5 1 1.5 80

90

100 Strike

110

120

90

100 Strike

110

120

The gures show deviations for option prices under normally distributed timing risk for European (solid line) and American (dotted line) option prices. The option prices are calculated for S0 = 100, T = 1, r = 0.05, = 0.3, and D Ntrunc (10, 1, 0, S0 ) or D ttrunc (10, 1, 1.5, 0, S0 ).

3.3

Uncertainty about ex-dividend date tD

We investigate the eect of uncertain timing of the ex-dividend date tD and assume that size D is known. We specied the domain for parameter tD by [t, ) at current time t. Opening the right boundary of the interval to allow for ex-dividend dates beyond the considered maturity date of the option turns the dividend ineective. We distinguish two types of domains. The rst type only captures uncertain movements within the time frame of the option, while the second imposes positive probability on the case that the ex-dividend date might be postponed to occur after maturity of the option. In the rst case, we model the randomness of tD by a truncated normal distribution restricted to the domain [0, T ]. To capture dividend movements beyond time of maturity, we consider a truncation at the lower boundary of the interval for the last time instant at t = 0.95 only. Figure 3 shows deviations of option prices derived under timing uncertainty from prices

11

assuming a known ex-dividend date5 . Both, European and American calls, are more valuable the later the dividend payment takes place. Assuming uncertainty about the timing of the dividend assigns probability to lower option prices and higher option prices. Due to the induced skewness of the truncated normal distribution, expected early dividend payments have large probability mass on higher option prices and later expected payments on lower option prices ranged. This leads to higher prices for low expectations about tD and lower prices for large expectations. In the case of a symmetric distribution, as for tD = 0.5, the eect is fairly small. The most interesting result occurs for unrestricted payment times. If the payment date is later than T , European options are valued without dividend and the American call will be equal to a European call. The value of a European call option signicantly increases whereas the American call is be devalued. In this case the intrinsic value of the option is subject to the largest risk. The simulation study shows that dividend uncertainty has only a negligible impact on short dated option pricing if dividend risk distribution parameters are chosen according to the empirically estimated ones. Hence dividend uncertainty needs not to be accounted for in this case. This conrms the results of Chance, Kumar and Rich (2000).

3.4

Measuring uncertainty in option prices

To analyze dividend risk embedded in observed option prices, theoretically equation (1) can be reversed to back out option implied dividend risk. We assume that a set of option prices V is observed in the market. Options traded in an ecient market are assumed to contain all relevant information concerning its underlying. Besides information about the distribution of asset price and future volatility, also inference on dividend payments can be drawn from market data. As we showed in the previous section, option prices accounting for dividend uncertainty should be priced dierently compared to those assuming certain dividends. Our aim is to gain information about the dividend parameters D. In a rst approach, we could back out these parameters the same way we calculate the implied volatility based on a set of option prices. But this approach leads only to a point estimate. In a second approach,
5

Table ?? in Appendix ?? provides the numerical values of the option prices.

12

we therefore reverse equation (1) and estimate the parameters of the assumed dividend distribution. To t the chosen parametric distribution function, we minimize the sum of squared distances between the theoretical and the market observed option prices V D . We solve the optimization problem V D (K, T )
K D

arg min

V (S, K, r, T, (K, T ), D)dF (D) .

(2)

The optimal dividend distribution is obtained by minimizing the expression with respect to the set of parameters for the assumed dividend distribution. As already mentioned, is the implied volatility of the closest option maturing before the dividend payment. The resulting estimates depend on the type of option pricing formula V () chosen in the minimization procedure. While pricing based on Haug et al. (2003) approach yields very accurate results, the reverse application of their formula is computationally very time-consuming. The approach of Bos and Vandermarks (2003) adjustment of the Black-Scholes formula yields good approximation results to the inversion of Haugs formula. But this approach suers from the following facts: If the number of option prices available is smaller than the number of parameters to be estimated minus the equality restriction on the weights, there are innitely many solutions to the problem. If options were traded for all maturities, comparison of option contracts with expiration right before and right after ex-dividend dates would allow to quantify the implied dividend risk. But options are not liquidly traded at all maturities at any time and the precision of the prices is not high enough to signicantly pin down the associated dividend risk. But we can estimate the price impact of dividend risk on long dated options using the above ndings in Section 3.3. We consider ESTOXX50 Options with a time to maturity larger than 2 years. Working with a t-distribution for dividend risk with = 3.04, = 0.31, = 0.52 we can estimate deviations of option prices relative to deterministic dividends. A simulation study shows that dividend uncertainty has only a negligible impact on short dated option pricing if dividend risk distribution parameters are chosen according to the empirically estimated ones. Hence dividend uncertainty needs not to be accounted for in this

13

case. This conrms the results of Chance, Kumar and Rich (2000). The impact of dividend risk on long dated option prices should not be negligible since analysts forecasts scatter much more for several years of dividend forecast. According to the above analysis this could be captured by imposing the particular distributional forms with time increasing volatility parameter. Modelling near dividends as deterministic in the shortrun and superimposing dividend risk on longer dated forecasts could improve option pricing for options with several years of maturity.

3.5

Quantifying dividend risk in a portfolio

We capture dividend uncertainty in terms of a parametric distribution function. We describe a simple example which quanties the dividend risk. We assume that at current time t = 0 we have a simple portfolio consisting of one long European call with strike K = 100 on a dividend-paying stock. The current stock price is S = 100. The option expires in one month. The ex-dividend date tD is in two weeks . The dividend is announced and distributed at the same date tD in unknown size D. We expect the dividend to be of size D = 10, based on analysts forecasts. What is the maximum loss at a signicance level of 99%, which our position is exposed to within the considered period of = 1/52, i.e. one week? We dene the prot and loss of our option position as

P &Lt+t = CE (t + t, St+t , Dt+t ) CE (t, St , Dt ),

(3)

where St+t and Dt+ denote the future values of the stock price and the markets expectation about the dividend, respectively. The remaining parameters are as usual assumed to be deterministic. Stock price S follows a lognormal distribution. To model the uncertainty about the dividend we propose a t-distribution with parameters D = D, D = 0.8, and D = 1.5. Both random variables are independent. The distribution of the P &L of the long call option at time t + t is shown in Figure 4. The upper graph shows the distribution when dividends and stock price are assumed to be

14

Figure 4: Loss distribution of the long call option

Risk Factors: Stock Price and Dividend 12000 10000 Frequency 8000 6000 4000 2000 0 0.6 0.4 0.2 0 0.2 0.4 Change in Value Risk Factors: Stock Price 0.6 0.8 1

12000 10000 Frequency 8000 6000 4000 2000 0 0.6 0.4 0.2 0 0.2 0.4 Change in Value 0.6 0.8 1

stochastic. The lower graphs shows the distribution under the assumption that the stock price is the only random variable in the model. We observe the familiar shape of the prot and loss distribution known from Black and Scholes option pricing. The P &L distribution accounting for dividend risk shows a stronger positive skewness than the P &L distribution assuming a known dividend. In the presence of dividend risk the maximum loss at a signicance of 99% is given by -0.5664, whereas it is given by -0.5521 for the deterministic dividend. We nd that accounting for dividend risk increases the potential loss of our position.

Alternative Dividend Model

In the previous section, we described methods how to extract dividend uncertainty implied in option prices. We did not model the dividend in its own right. In the following, we propose a forecasting model for the next dividend. The model predicts dividends based on available stock price and earnings information. To motivate the formulation of our dividend model, we summarize the most important ndings which explain managers decisions in setting a dividend policy. In an empirical

15

study, Lintner (1956) investigates the behavior of a sample of US rms in their determination of dividend policy. He nds that managers change dividends primarily in response to unanticipated and non-transitory changes in earnings. Changes are avoided, if they might have to be reversed within the next year. Investment requirements are found to have little eect on the modication of dividend policy. He proposes a partial adjustment model which explains dividend behavior of rm i by
Dit = ai + ci (Dit Di,t1 ) + Uit ,

(4)

= E is a xed fraction of the current periods earnings and is referred to as where Dit it

payout ratio. The regression parameter ci is interpreted as speed of adjustment. ai and Uit are a constant and an error term, respectively. In a separate study, Fama and Babiak (1968) conrm these ndings. Stacescu (2004) examines dividend policy for a large sample of Swiss companies. He nds that Lintners model works reasonably well for a large number of rms. Price volatility is identied as the major factor in determining cross-sectional dividend policy. Furthermore, he identies a signicant relationship between losses and dividend cuts. Lintners model provides good predictions for the size of the next dividend payment of companies in a nancially stable situation. Limitations become apparent when a dividend cut is considered. According to the model, dividend cuts are only predictable, if the current earnings are zero. Sharp declines in earnings lead to a small dividend forecast. This corresponds only to some extent to reality. Companies are forced to leave their targeted dividend policy due to nancial distress. Being left with the choice of distributing a fairly small dividend or cutting the dividend to zero, most companies prefer the latter of the two options. This behavior should also be preferred by investors, who are aware of the situation of the rm. Instead of receiving a negligible dividend amount, the remaining cash resources should be employed to nancially stabilize the company. To better explain the event of a dividend cut, we propose an enhancement of the basic Lintner model. Stock prices of rms show a more volatile pattern, if these exhibit nancial distress. We propose to enhance the basic Lintner

16

model to account for the shortfall risk of the stock over a specied time period to predict dividend cuts. This allows us to signicantly improve the forecasting performance of dividend cuts while maintaining the explanatory power of the Lintner model. In the following section, we outline the basic model idea. We provide a measurement tool of the dividend with respect to dividend cuts. Finally, we provide empirical examples for the performance of the enhanced model.

4.1

The model

At current time t we observe stock price St , earnings Et , and past dividend payment Dt1 . We assume that dividends have dynamics given by a + c(Et Dt1 ), SF (t) < R Dt1 , SF (t) R.

Dt =

(5)

If the shortfall risk SF over a specied time horizon t is smaller than some barrier R > 0 at a given signicance level , we expect the next dividend to correspond to the prediction of the Lintner model. If the shortfall risk exceeds R, the change in the dividend is given by the negative amount of the last dividend, eectively setting the next dividend to zero. In this model, we assume that dividends are always paid at a xed ex-dividend date tD . The time step t should be chosen in such a way that it reects the time horizon considered by rms dividend policy. According to the empirical research mentioned in the last section, it is reasonable to consider a planning horizon of one year for Swiss stocks, such that t = 1. The considered time interval contains tD , but is not limited by tD , i.e we assume t < tD < t + t. Thus, we do not consider a shortfall at the ex-dividend date, but until the end of the rms planning horizon. In the following, we refer to predictions for the next dividend to be paid at tD , which are formed on basis of the Lintner model, as E [D] = D. Consequently, for the second, case the expectation reduces to E [D] = 0. The stock price diusion process S follows a geometric Brownian motion with volatility . Furthermore, the lower barrier R, which reects the maximum stock price level for which we do not expect to receive a dividend is given. The 17

Figure 5: Stock price process and barrier

The gure depicts a stock price process as realized until time t = 0.5. The considered time horizon is t = 1. Given the barrier R (thick dashed line) the probability of a shortfall at time t + t has to be determined.

bound R is deterministic and has dynamics

dRt = rRt dt,

(6)

i.e. it grows at the risk-free rate. The area below R corresponds to E [D] = 0. If St+t > R, we expect to receive D, if St+t R, we expect that the dividend is cancelled. Since we do not know the stock price level St+t beforehand, we have to determine the probability of this shortfall for time t + t given the information at current time t. Figure 5 provides an example for this set up. We assume that at time t = 0.5 we have dividend expectation D to be paid at ex-dividend date tD . We consider the shortfall risk over the planning horizon t = 1. We set a barrier R reecting our view on the critical stock price level, which might cause a withdrawal of the proposed dividend. In order to quantify the risk of a dividend cut, we have to determine the depicted probability of a shortfall below R at t + t.

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4.2

Critical dividend line

Given the size of barrier R at time t, the general form of the stock price process, and a condence level , we can now determine the combinations of current spot price St and stock price volatility , which correspond to either E [D] = D or E [D] = 0. We denote the line, which separates both regions, as the critical dividend line. Pairs (St , ) which are positioned above this line belong to the critical dividend region. In this region, we have a lower than condence in receiving the full dividend amount and hence assume E [D]=0. The critical dividend line is constructed as follows. Given the barrier R we calculate the probability of a shortfall of S below R within time t as P St+t ert R = P St e(r
2 )t+Wt 2

ert R

= P Wt ln

R 2 + t St 2
2

ln R + t = P Z St 2 t = N (a),
ln
2 R + t St 2

(7)

where a =

and the random variable Z has a standard normal distribution with

distribution function N (). The condence level of a shortfall is given by = 1 N (a). Holding the condence level xed, we determine the combinations of stock price level S and volatility which correspond to the boundary of the critical dividend set. Hence, we calculate the values of S and for which the corresponding shortfall size given the condence level exactly amounts to R. From the above it follows that a corresponds to the (1 )-quantile Q1 of the standard normal distribution. Thus, we can use the equality a = Q1 and solve for boundary R. This yields R = St e
t tQ1 2
2

(8)

Since S and are assumed to be the only variable parameters, we can express the critical dividend boundary as a function of of S . Solving equation (8) for , we obtain the quadratic

19

function 2 t R tQ1 + ln = 0. 2 St (9)

Focusing on the positive solution, we obtain an expression for the critical dividend line D given by Q1 D(St ) = + t Denoting the root by h= Q2 2 R 1 ln , t t St (11) Q2 2 R 1 ln . t t St (10)

the rst and second partial derivatives of D with respect to St are given by 1 D = S 2Sht and 2D 1 1 1 + = 2 , S 2 2S t 2h3 t h (13) (12)

respectively. It follows that D is strictly increasing and concave in S . Figure (6) depicts the critical dividend line for dierent levels of . The more conservative the choice of , the atter the corresponding curve. The critical dividend region is the area above the curve. Observing the historical stock prices for company Z, we determine an estimate for the volatility . Having specied an exact value for barrier R, we are now able to position a company in this setup. If it is located above the critical dividend line, we expect a dividend cut, otherwise, i.e. if it is located below this line, we expect to receive the dividend D.

4.3

Alternative denition of shortfall

Up to now we only dealt with the probability that the stock price process S is smaller than some barrier R at time t + t. It might also be worthwhile to consider the probability that S is below the boundary at some time before t + t. Expressing this in terms of our dividend model, we state that if the minimum of the stock price process S is below the boundary R during the time interval [t, t + t], then we expect a dividend cut.

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Figure 6: Critical dividend line

0.7

0.6

0.5

Volatility

0.4

0.3

0.2 = 0.9 = 0.95 = 0.99

0.1

0 20

40

60

80 100 Price Level

120

140

160

The gure depicts the critical dividend line D. It is shown for three dierent condence levels . The dashed vertical line marks the barrier on the stock price level. The critical dividend region is the area above the curve. The more conservative we choose , the larger becomes the critical dividend region.

This probability is given by min (ers St+s ) R = P R 2 s + Ws ) ln 2 St

0st

0st
2

min (

(14)

R Using the result in Appendix A and setting = 2 and u = ln St we obtain R R + t ln S t ln S St t t 2 2 St+s ) R = N + N . R t t

2 2

0st

min (e

rs

(15)

Since we cannot determine the critical dividend lines D analytically, we use numerical techniques. Figure 7 provides a comparison for the two dierent probabilities. The shape of D is similar for both approaches. The extreme value specication appears to be more conservative due to the comparably higher probability of the occurrence of a shortfall.

21

Figure 7: Comparison of critical dividend lines from both approaches

0.6

0.5

Volatility

0.4

0.3

0.2 Shortfall Probability 1 Shortfall Probability 2

0.1

0 20

40

60

80 100 Price Level

120

140

160

The gure depicts critical dividend lines for condence level = 0.9. Probability 1 measures shortfall likelihood at the end of the time period and probability 2 accounts for the distribution of the minimum values of the process during the considered time interval. The thick dashed line represents the boundary for the dividend cut.

4.4

Estimation

The most crucial model parameter to be determined is the shortfall barrier R. Since optimization of the estimation error with respect to R turns out to be numerically dicult, due to a non-convex objective function in R, we propose to evaluate the model for a wide range of possible values of R. For each single R the available data is split into years with shortfall risk exceeding R and years where the shortfall risk is smaller than R. For the rst sub-sample, the forecasted change in dividends is zero, i.e. we predict a dividend cut. In the second sub-sample the forecast is based on the Lintner model evaluated on the sub-sample. We suggest to apply a simple ordinary least squares approach to estimate the model

Dt Dt1 = b0 + b1 Et + b2 Dt1 + Ut ,

(16)

22

where U is the error term. The original model parameter speed of adjustment is given by
1 c = b2 and the target payout ratio by = b b2 . The optimal R is chosen to minimize the

squared estimation error for the entire sample.

4.5

Empirical analysis

We test the specied model on a sample of 34 Swiss stocks. Since our model attempts to improve the explanatory power of the Lintner model for companies exhibiting dividend cuts, we focus in the analysis on stocks, which have a dividend cut at some point during the time period considered. Many of the companies follow a constant positive dividend policy, or do not pay any dividends at all for most of the time period. For these companies the enhanced model does not provide signicant improvements. We reduce the total sample to a subsample of 6 Swiss stocks, which constantly paid dividends with the exemption of dividend cuts. The data set is provided by Datastream. We consider a sample of data from 1975 to 2005. The data set consists of stock prices (S), earnings per share (EPS), and dividends per share (DPS). Some of the companies are not available for the whole period, which reduces the number of usable observation for those stocks. Stock prices are available on a daily basis, while earnings and dividends are only reported in quarterly or yearly frequency. Figure 9 in Appendix B shows stock prices and dividends for each considered company. We observe a clear positive dependence between the dividend size and the level of the stock price. Nevertheless, the ratio of dividend and stock price level is not constant over time. Dividend cuts seem to follow extreme movements in the stock price. This becomes most apparent in the case of Credit Suisse and ABB. The explosive behavior of the price process in the late 90s is followed by constantly increasing dividends. The crash in 2001 leads to dividend cuts. For the estimation of the model we restrict ourselves to yearly data. Since we assume that dividend policy is made for the whole nancial year, we x the yearly data points at the begin of each considered year. Dividends used correspond to the realized dividends for each year. The volatility estimate is based on log-returns of the preceding year. Figure 10 in Appendix B depicts the explanatory variables. A positive dependence of earnings and 23

Table 2: Estimation results for the Lintner model and the enhanced model for a sample of 6 Swiss stocks b0 0.20 (0.11) 0.23 (0.21) -0.11 (0.18) 1.20 (1.21) -0.03 (0.02) 0.07 (0.10) Lintner b1 0.28 (0.04) 0.07 (0.11) 0.18 (0.07) 0.23 (0.08) 0.27 (0.04) 0.11 (0.05) Model b2 -0.99 (0.13) -0.37 (0.31) -0.51 (0.28) -1.38 (0.25) -0.63 (0.11) -0.69 (0.21) R2 0.66 0.43 0.74 0.55 0.85 0.57 Enhanced b0 b1 0.04 0.23 (0.08) (0.03) 0.23 0.07 (0.21) (0.11) -0.28 0.10 (0.41) (0.23) 0.64 0.24 (0.95) (0.06) -0.00 0.06 (0.01) (0.03) 0.13 0.01 (0.11) (0.06) Model b2 -0.58 (0.11) -0.37 (0.30) 0.16 (0.52) -1.14 (0.21) -0.08 (0.10) -0.21 (0.27) R 0.57 0.53 0.64 0.71 0.65 0.62 R2 0.87 0.43 0.85 0.76 0.96 0.70

Credit Suisse UBS Clariant Sarna ABB Ascom

Numbers in brackets denote the standard deviation of the respective parameter estimate. The star indicates signicance at the 5% level.

Table 3: Comparison of speed of adjustment and target payout ratio between original and modied model Lintner c 0.99 0.28 0.37 0.19 0.51 0.35 1.38 0.17 0.63 0.37 0.69 0.16 0.76 0.25 0.37 0.09 Enhanced c 0.58 0.40 0.37 0.19 -0.16 -0.63 1.14 0.21 0.08 0.75 0.21 0.05 0.37 0.16 0.45 0.46

Credit Suisse UBS Clariant Sarna ABB Ascom Mean SD

dividends can be observed for all considered rms. Despite of this evidence for correlation, we nd that dividends show much less uctuations than earnings do. Periods of low earnings mostly correspond to high volatility of the stock price and low or cancelled dividends. On the other hand, zero dividends do not always imply zero earnings. This justies the criticism on the Lintner model mentioned in the beginning of this section. We discuss the estimates of the model for each stock in the subsample. Table 2 summarizes

24

the estimation results for the original Lintner model and provides the comparable numbers from the estimation of the modied model. We nd that the intercept b0 is insignicant for both models. There seems to be consensus about the respective sign of b1 and b2 across the dierent stocks and models. We nd that earnings have a positive impact on the dividend change, while the previous dividend enters with a negative sign. This corresponds to the postulations of Lintners model. Nevertheless, the actual size of the estimates strongly varies across the dierent stocks. The barrier estimates R vary between 0.53 and 0.71. This implies that an expected shortfall of the stock price to 50% of its current value within the considered nancial year leads to a cut of the dividend for all companies. The enhanced model shows an overly higher R2 than the simpler model version. This is not surprising, since the second model is an extension of the original one, which cannot perform worse in terms of in-sample estimations. Hence, our model improves the explanatory power of the Lintner model. The translation of the estimation parameters to corresponding dividend model parameters is provided in Table 3. The mean of the estimated parameters speed of adjustment c and target payout ratio in Lintners model is similar to those reported in Stacescu (2004), who used a signicantly larger sample. The mean of the estimated parameters in the enhanced model turns out to be lower for both parameters. Since our model explains dividend cuts, which are not necessarily explained by the original Lintner model, we believe that our model parameters give a better picture of the actual rms dividend policy parameters. The upper diagrams of Figures 11 to 13 in Appendix B show the tted values from dividend estimation for Lintners and the enhanced model. For all stocks, except for the case of UBS, the enhanced model proves to be superior compared to the Lintner model. We nd a better t in case of dividend cuts and also an improvement in the remaining overall t. For UBS we observe equivalence in dividend estimates for both dierent models. The middle and lower diagrams show dividend forecasts based on out-of-sample predictions for both of the two discussed measures of the shortfall probability. Due to model calibration, we do not use the entire sample period, but consider a shorter time window for prediction. Out-of-sample forecasts of the Lintner model prove to be more accurate for the stocks UBS and Credit Suisse. For Clariant, Sarna, ABB, and Ascom our model is a signicant improvement

25

Figure 8: Dividend early warning system for ABB in 2001.

0.8 0.7 0.6 0.5 Volatility 01Nov2001 0.4 01May2001 0.3 0.2 0.1 0 02Jul2001 03Sep2001 Shortfall Probability 1 Shortfall Probability 2

10

15

20 25 Price Level

30

35

40

The gure shows critical dividend lines for ABB determined after the dividend payment in 2001. The circles denote the price/volatility pairs during the remainder of 2001.

over the original model. In case of ABB and Ascom, the enhanced model is able to exactly predict the dividend cuts in the past 5 years. While modelling dividend changes in terms of Lintners model leaves room for discussion, the performance of the enhanced model can be utilized in an early warning system for dividends. We assume we have a view D on the next dividend. This view might be given by the Lintner model. As we already mentioned, when deriving the critical dividend line, we can construct a graph like Figure 6 based on our barrier estimate R. We can position the stock according to price level and volatility in this picture. This allows us to draw inference about the uncertainty of the next dividend payment. If we nd the company positioned above the critical dividend line, we expect the next dividend to be cut. If it is positioned below the line, we expect the dividend to follow our view D. Figure 8 shows an example of a dividend early warning system for ABB in the year 2001. In the rst half of the year dividends are still expected to be paid according to our view. If we formed this view based on the Lintner model, we would expect a signicant positive dividend payment for the next year. In the second half of 2001, ABB share price drops further and 26

volatility increases. We nd the stock positioned above the critical dividend line, implying that we expect a dividend cut according to our model. Eventually, the dividend for the nancial year 2001 was cut.

Conclusion

We approach dividend risk from dierent perspectives. Based on an empirical comparison between forecasted and realized dividends, we propose to describe dividend risk by a truncated t-distribution. In a simulation study, we nd that dividend uncertainty has an impact on option pricing. This eect, however, is of negligible size, if the dividend risk distribution parameters are chosen according to the empirically estimated ones and if one consider short maturity options. To analyze dividend risk contained in observable option prices, we outline a methodology to draw inference on the implied dividend uncertainty. Satisfactory application of the methods to market data is dicult for two major reasons: Firstly, the precision of option prices is not as high as would be required to accurately measure the presence of dividend risk. Secondly, the in the market available set of options of dierent strikes with the same maturity is too small. Since the impact of dividend risk on long dated option prices should not be negligible there is a natural need to model dividend risk for options with several years of maturity. The market for structured products is a concrete case where the need exists. Among thee huge variety of dierent payos, we consider the structures oering 1:1 participation in an underlying at less of a price than the actual value of the underlying instrument. Such payos are nanced by dividends, i.e. by simply withholding dividend payments which occur during the lifetime of the product. In this way, appealing discounts for longer dated structures on high dividend paying stocks or indices can be oered and investors holding this kind of certicate are eectively short dividends. The certicated structure crucially depends on the expectation about the size of the future dividend payments. If future dividend payments were known, the oered discount should be nearly the same across the whole market. But since dividends can only be regarded as certain after they have been announced, dividend forecasts

27

are needed. Defensive dividend estimations will lead to a less appealing discount such that the trade will be lost, while aggressive dividend forecasts might result in a negative P& L at expiration of the issued certicate. Finally, we suggest a dividend model, which allows to predict dividend cuts based on the stocks shortfall risk. The model improves the forecasting performance of Lintners (1956) model. The dividend early warning system is able to predict dividend cuts during the nancial year.

28

References
[1] Black, Fischer, and Myron S. Scholes, 1973, The pricing of options and corporate liabilities, Journal of Political Economy, 81, 637-659. [2] Bos, Remco, Alexander Gairat and Anna Shepeleva, 2003, Dealing with discrete dividends, Risk, 16 (1), 109-112. [3] Broadie, Mark, J er ome Detemple, Eric Ghysels, and Olivier Torr es, 2000, American options with stochastic dividends and volatility: a non-parametric investigation, Journal of Econometrics, 94, 53-92. [4] Chance, Don M., Raman Kumar and Don Rich, 2000, Dividend forecast biases in index option valuation, Review of Derivative Research, 4, 285-303. [5] Chance, Don M., Raman Kumar and Don Rich, 2002, European option pricing with discrete stochastic dividend, Journal of Derivatives, Spring, 39-45. [6] Fama, Eugene F., and H. Babiak, 1968, Dividend policy: an empirical analysis, American Statistical Association Journal, 63, 1132-1161. [7] Geske, Robert, 1978, The pricing of options with stochastic dividend yield, Journal of Finance, 33 (2), 617-625. [8] Haug, Espen G., Jrgen Haug and Alan Lewis, 2003, Back to basics: A new approach to the discrete dividend problem, Wilmott Magazine, 9. [9] Lintner, John, 1956, Distribution of incomes of corporations among dividends, retained earnings, and taxes, American Economic Review, 46, 97-113. [10] Roll, Richard, 1977, An analytic valuation formula for unprotected American call options on stocks with known dividends, Journal of Financial Economics, 5, 251-258. [11] Shimko, David, 1993, Bounds of probability, Risk, 6, 33-37. [12] Stacescu, Bogdan, 2004, Dividend policy in Switzerland, University of Z urich, Working Paper. 29

Minimum of a Brownian motion with drift

We want to show that

2u u t u + t + e 2 N . t t

0st

min (s + Ws ) u = N

Let g be a Brownian motion with drift given by

g (t) := t + Wt , We dene its minimum m over the interval [0, t] as

g (0) = 0.

m(t) := min g (s).

0st

Consider the probability

P m(t) u = P m(t) u, g (t) u + P m(t) u, g (t) u

Let Wt = Wt + t be a change of measure with Radon-Nikodym derivative
> dP dP

(17)
1 2

= e W t 2 ( ) t .

We start with the rst term of the right-hand side of (17) and the change of measure yields

P m(t) u, g (t) u

= E I{m(t)u, g(t)u} = E e WT 2 ( ) T I{m(t)u, g(t)u}

? 1 2

Noticing that g (t) = Wt and m(t) = min0st Ws , we apply the reection principle for a Brownian motion without drift and obtain = E e (2W WT ) 2 ( ) T I{W ?t u }

P m(t) u, g (t) u

1 2

= e

2u 2

E e

? WT 1 ( )2 T 2

I{W ?t u } .

30

 A second change of measure dened by Wt = Wt + t with

A dP > dP

= e W t 2 ( )

1 2 t

yields

P m(t) u, g (t) u

= e 2 E I{W Bt u + t} u + t = e P Wt 2u u + t 2 = e N t
2u 2

2u

The second term in (17) reduces to

P m(t) u, g (t) u

= P g (t) u u t u t = N . t = P Wt

The result follows. Similarly, it can be shown for the maximum that
2v v + t t v + e 2 N . t t

0st

max (s + Ws ) > v = N

31

Data Summary
Figure 9: Stock prices and dividends for a sample of 6 Swiss stocks.

CREDIT SUISSE 90 5 80 70 60 Stock Price Stock Price Dividend 50 40 2 30 20 10 0 0 0 1 40 3 4 80 100 120

UBS 9 8 7 6 5 60 4 3 2 20 1 0 Dividend Dividend Dividend 5 0 1991 1993 1994 1995 1997 1998 2000 2001 2002 2004 2005 ASCOM 3 200 1.4 2.5 1.2 150 1 0.8 0.6 1 0.4 0.2 0 0 1984 0 50 0.5 Stock Price Dividend 2 1.5 1987 1990 1993 1995 1998 2001 2004

1976 1979 1982 1984 1987 1990 1993 1995 1998 2001 2004

1976 1979 1982 1984 1987 1990 1993 1995 1998 2001 2004

CLARIANT 100 90 80 70 Stock Price 60 50 40 1 30 20 10 0 1997 1998 2000 2001 2002 2004 2005 0 0 0.5 1.5 Dividend 2 Stock Price 200 2.5

SARNA 15

250

10

150

100

50

ABB 45 1.6 40 35 30 Stock Price 25 20 15 10 5 0

100

1976 1979 1982 1984 1987 1990 1993 1995 1998 2001 2004

The pictures show stock prices (blue) and dividends (red) for a sample of 6 Swiss stocks. We can observe a relationship between stock price level and dividend size. Dividend cuts seem to follow extreme downward movements of the stock price.

32

Figure 10: The relationship between EPS, DPS and Volatility

CREDIT SUISSE 0.7 5 4.5 4 CHF Per Share 3.5 Volatility 3 2.5 0.3 2 1.5 1 0.1 0.5 0 1980 1985 1990 1995 2000 0 2005 1 0 0.2 2 0.4 0.6 7 6 CHF Per Share 5 4 3 8

UBS 0.5 0.45 0.4 0.35 Volatility Volatility 0.3 0.25 0.2 0.15 0.1 0.05 1980 1985 1990 1995 2000 0 2005

0.5

CLARIANT 3.5 0.6 18 16 0.5 2.5 CHF Per Share 0.4 2 0.3 1.5 0.2 1 0.1 2 0 2005 0 Volatility CHF Per Share 14 12 10

SARNA 0.4 0.35 0.3 0.25 0.2 8 0.15 6 4 0.1 0.05 0

0.5

0 1997

1998

1999

2000

2001

2002

2003

2004

1994

1996

1998

2000

2002

2004

ABB 1.5 2 5

ASCOM 1 0.9 4.5 0.8 4

1.5 CHF Per Share

CHF Per Share

1 Volatility

3.5 3 2.5 2 1.5

0.7 Volatility 0.6 0.5 0.4 0.3 0.2 0.1 1988 1990 1992 1994 1996 1998 2000 2002 2004 0

1 0.5 0.5

1 0.5 0 1975 1980 1985 1990 1995 2000 0 2005 0 1986

The pictures show earnings per share (solid line), dividend per share (dashed line), and stock price volatility (dotted line) for a sample of 6 Swiss stocks.

33

Figure 11: UBS: Realized dividends, tted dividends, and forecasted dividends.
CREDIT SUISSE Fitted Values 2 Dividend 1 0

1980 1985 1990 1995 2000 OutOfSample Forecast Using Shortfall Probability 1

2005

Dividend

2 1 0

1992

1994 1996 1998 2000 2002 2004 OutOfSample Forecast Using Shortfall Probability 2

Dividend

2 1 0

1992

1994 Realized

1996

1998 2000 Lintner Model

2002 2004 Enhanced Model

Figure 12: Credit Suisse: Realized dividends, tted dividends, and forecasted dividends.
UBS Fitted Values Dividend 3 2 1 0 1980 1985 1990 1995 2000 OutOfSample Forecast Using Shortfall Probability 1 2005

Dividend

2 0

1992

1994 1996 1998 2000 2002 2004 OutOfSample Forecast Using Shortfall Probability 2

Dividend

2 0

1992

1994 Realized

1996

1998 2000 Lintner Model

2002 2004 Enhanced Model

34

Figure 13: ABB: Realized dividends, tted dividends, and forecasted dividends.
ABB Fitted Values Dividend 0.6 0.4 0.2 0 1980 1985 1990 1995 2000 OutOfSample Forecast Using Shortfall Probability 1 2005

Dividend

0.5

1992

1994 1996 1998 2000 2002 2004 OutOfSample Forecast Using Shortfall Probability 2

Dividend

0.5

1992

1994 Realized

1996

1998 2000 Lintner Model

2002 2004 Enhanced Model

35