How Dividends Affect Stock Prices | Relationship between Dividend and Share Price | Motilal Oswal
How Dividends Affect Stock Prices | Relationship between Dividend and Share Price | Motilal Oswal

How Dividends Affect Stock Prices

When a mutual fund declares a dividend on one of its schemes, what happens? The answer is obvious; its NAV falls to the tune of the dividend. For example, if an equity fund has a growth option and a dividend option and if their NAVS are at Rs.18, what happens if there is a dividend of Rs.4/unit declared. The NAV of the growth fund will remain the same but the NAV of the dividend fund will fall from Rs.18 to Rs.14. The relationship is very clear in case of mutual funds. But, what about dividends declared on equity?

 

The impact is somewhat the same in case of equities too, although the relationship is not as precise as in case of mutual funds. When a company declares dividends, it is tantamount to partial liquidation of the company’s profits. It also means that the shareholders can get better yield in the form of dividends than by ploughing the profits back into the company. To that extent there will be a downward impact on the stock price too. The stock price will adjust downward in response to dividends on the ex-dividend date.

 

But does the dividend amount impact the price of stock futures?

That is an interesting question. If you are holding on to a stock, then you receive dividends into your bank account. So your receipt of dividend gets adjusted to the stock price so that the wealth effect remains neutral. That is perfectly understandable. But, what if you are holding stock futures? You do not receive any dividends if you are holding on to stock futures. Then why should the adjustment happen to futures price. The answer lies in the fact that the stock future is a derivative product and its value is derived from the underlying which is the stock price. Let us now understand the effect of dividend on futures price. How do dividends affect futures prices and what is the impact of dividend on stock price. The best way to understand this relationship between dividends, stock price and futures price is through an arbitrage example.

 

Understanding the dividend relationship through arbitrage

One of the popular strategies in the stock market is to create a cash futures arbitrage. Futures price normally quote at a premium to the stock price and that is called the cost of carry. This price difference between the stock price and the futures price is the arbitrage spread and is the assured return for the arbitrageur. This is how it works:

 

Stock of X Ltd.AmountFutures of X Ltd.AmountAmount bought1000 sharesLot size1000 sharesPrice of stockRs.800Price of FuturesRs.806Arbitrage SpreadRs.6Arbitrage Yield0.75%

Annualized Yield9.38%

 

This is the kind of annualized returns that you can approximately earn on arbitrage although the rates will keep varying month on month depending on the market conditions and the liquidity conditions. So what will the arbitrageur do? They will buy in the cash market and sell in the futures market. Here is what it will look like..

 

Buy in cash marketAmountSell in futures marketAmountBought atRs.800Sold atRs.806Price on expiryRs.773Price on expiryRs.773Loss on cash positionRs.(-27)Profit on short futuresRs.33Assured profit on ArbitrageRs.6 (33 – 27)

 

In the above case, the assured profit will be Rs.6 irrespective of whether the expiry price is below Rs.800 or above Rs.900. That is the way arbitrage works. Of course, you will not realize the entire Rs.6 as profit as there will be transaction costs and statutory costs that you will have to pay and your arbitrage yield will stand reduced to that extent.

 

Coming back to dividend impact on stock futures

Let us extend the above arbitrage example to understand how dividends impact the futures price. Let us assume that the company declared a dividend of Rs.5 and so the stock price adjusted downward by Rs.5 while the futures price did not. What happens then?

 

Cash legAmountFutures LegAmountBought atRs.800Sold  at Rs.Rs.806Dividend declaredRs.5Arbitrage SpreadRs/6Ex-dividend cash priceRs.795New arbitrage spreadRs.11New arbitrage yield1.38%New annualized yield17.88%

 

In the above case, the cash price has adjusted for the dividend but the futures price has not. As a result, the arbitrage yield has shot up from Rs.0.75% per month to Rs.1.38% per month. That is nearly 17.88% annualized yield and you cannot get such returns even on equity funds. Obviously, there will be a rush by arbitrageurs to create fresh arbitrage positions in this stock. Since there will be a heavy demand to buy the stock in cash and sell in futures, the spread will quickly compress back to the old rate of 0.75%. This normally happens by the futures price falling proportionately.

 

That is how futures price adjusts to dividend declaration. It is more because the arbitrage opportunity opens up a huge short demand for futures and long demand for the stock. However, in reality this happens much more seamlessly and the impact on futures price is almost immediate!
 

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