0.,,,,, I: Definitions 21 
A word of caution: Do not conclude from this discussion that a call will be exer­
cised for the dividend if the dividend is larger than the remaining time premium. It 
won't. An example will show why. 
Emmple: XYZ stock, at 50, is going to pay a $1 dividend with the ex-date set for the 
next day. An XYZ January 40 call is selling at 10¼; it has a quarter-point of time pre­
mium. (TVP = 10¼ + 40 - 50 = ¼). The same type of arbitrage will not work 
Suppose that the arbitrageur buys the call at 10¼ and exercises it: He now owns the 
stock for the ex-date, and he plans to sell the stock immediately at the opening on the 
ex-date, the next day. On the ex-date, XYZ opens at 49, because it goes ex-dividend 
by $1. The arbitrageur's transactions thus consist of: 
1. Buy the XYZ January 40 call at 10¼. 
2. Exercise the call the same day to buy XYZ at 40. 
3. On the ex-date, sell XYZ at 49 and collect the $1 dividend. 
He makes 9 points on the stock (steps 2 and 3), and he receives a 1-point dividend, 
for a total cash inflow of 10 points. However, he loses 10¼ points paying for the call. 
The overall transaction is a loser and the arbitrageur would thus not attempt it. 
A dividend payment that exceeds the time premium in the call, therefore, does 
not imply that the writer will be assigned. 
More of a possibility, but a much less certain one, is that the arbitrageur may 
attempt a "risk arbitrage" in such a situation. Risk arbitrage is arbitrage in which the 
arbitrageur runs the risk of a loss in order to try for a profit. The arbitrageur may sus­
pect that the stock will not be discounted the full ex-dividend amount or that the 
call's time premium will increase after the ex-date. In either case (or both), he might 
make a profit: If the stock opens down only 60 cents or if the option premium 
expands by 40 cents, the arbitrageur could profit on the opening. In general, howev­
er, arbitrageurs do not like to take risks and therefore avoid this type of situation. So 
the probability of assignment as the result of a dividend payment on the underlying 
stock is small, unless the call trades at parity or at a discount. 
Of course, the anticipation of an early exercise assumes rational behavior on the 
part of the call holder. If time premium is left in the call, the holder is always better 
off financially to sell that call in the secondary market rather than to exercise it. 
However, the terms of the call contract give a call holder the right to go ahead and 
exercise it anyway - even if exercise is not the profitable thing to do. In such a case, 
a writer would receive an assignment notice quite unexpectedly. Financially unsound 
early exercises do happen, though not often, and an option writer must realize that,