Dividend Protection at a Price

Abstract

A call option conveys the right to pay the strike price and acquire the underlying stock on (or before) the option's maturity date. This allows the option holder to participate in capital gains on the underlying, but not in its dividend payout. The problem is relatively minor for short maturity contracts, because there are few dividends involved and their amounts are predictable. But for long maturity calls, or warrants, dividend uncertainty becomes a significant issue. One solution is the Australian “endowment warrant,” a long-term contract whose strike price is adjusted downward each time the underlying stock pays a dividend. As Brown and Davis show in this article, the result is a derivative contract with partial, but not complete, protection against future dividend payout. They also provide a new valuation model to correct flaws in the previous methodology.