The Ex-Dividend Day Behavior of Option Prices

Abstract

A security purchased at the opening of trade on the ex-dividend day does not include a claim to the dividend announced earlier, yet if purchased on the previous day (the last cum-dividend day) it does. Thus, the price of a security that goes exdividend is expected to drop in this time interval. The expected price drop around the ex-dividend day has been compared to the dividend per share in various past studies (Campbell and Beranek 1955; Durand and May 1960; Elton and Gruber 1970; Kalay 1982). The documented behavior of stock prices around the ex-dividend day seems to be consistent with market efficiency, that is, it provides no profit opportunities. An interesting question that arises is whether the discontinuity in the stock price carries over to call options on the stock with similar implications for market efficiency. Because call options are unprotected against payment of dividends, their pricing has to take into account the change in the value of the underlying asset around the ex-dividend day. This point has been recognized in the literature since It is well known that the price of a share of common stock is expected to drop around the ex-dividend day. Since call options written on such underlying shares are not protected against dividend payment, a question arises as to the behavior of the prices of call options around the exdividend day. Assuming a rational exercise policy on the part of investors, it can be demonstrated that the price behavior of American call options around the ex-dividend day should not be different from that on any other arbitrarily chosen day. However, our empirical analysis using both parametric and nonparametric methods indicates that, perhaps because of a wrong exercise policy on the part of investors, abnormal returns are observed in certain cases. This finding casts some doubt on the presumption of efficiency of the American call option market around the exdividend day. * We wish to thank John Long, Stanley Kon, Clifford Smith, Jeremy Bulow, and Harry Friedman for helpful comments on earlier drafts of this paper. We are also indebted to David Cho and Elli Kraizberg for their assistance. Finally, the financial support of the Salomon Brothers Center for the Study of Financial Institutions, New York University, is gratefully acknowledge.