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