This is from Pensions EOC 18. How do you connect high dividend yield to low option cost? I cannot think anymore.
Thanks guys,
P
I’m not sure how it relates to pensions. I suppose it relates to the share-based compensation section of reading 24. I’d think of it like this:
High dividend yields means less growth potential. Lower growth stocks are traditionally less volatile (imagine utilities). Lower volatility stocks will obviously have lower option costs.
P.S. I’m not sure if this is how CFAI justifies it, but this makes sense to me! So, I’d appreciate some additional feedback too.
Just use call-put parity formula and you will get the idea
I think (but could be wrong!) that the call option on a stock that pays dividends will be worth less than the call option on a stock that does not pay dividends. This is because a dividend is a cash flow back to the investor, which, according to the curriculum, will decrease the price of the stock. Call option value decreases as stock prices decrease (although remember from Corp Finance that an investor’s overall wealth is the same).
Obviously, the opposite is true for put options. A put option on a dividend-paying stock will actually be worth more than a put option on a non-dividend-paying stock because put option value is inversely related to stock price.
I think about it as, a dividend makes it less likely, all else equal, that the price of the stock will reach its call strike price. Conversely, a dividend makes it more likely it will decline to hit its put strike price.
The cash flow from a security reduces the price of the option because the holder of the option doesn’t receive those cash flows, so they are going to pay less.
If a security is valued as the present value of all future cash flows, the value of the cash flow is less if you don’t have the ability to receive one of those cash flows (in the case of an option, its the cash flow between now and the time the option expires).