I don’t fully understand the rationale of subtracting the value of dividend from spot price of stock before ariving at a value/price of equity forward contract. The short to contract has obligation to deliver stock only at expiry and long to contact is supposed to pay agreed price at expiry. Infact short has the underlying stock in his/her possession is immaterial. It is short responsiblity (and he/she bears risk) to deliver at expiry date anyhow.
I see this as a situation where long don’t have any claim on stock before expiry and as a matter of fact the long has also not paid anything to short so why before pricing the contract, the price has to subtract the value of dividend. The long will any will get stock at expiry so why he/she should get benefit by reducing the value of dividend from contract price.
What if the company don’t pay or skip the dividend duirng equity forward contract tenure. If this happens then short will run into loss becuase on one side the contact is priced by removing dividend and on other side he/she didn’t get dividend on due/expected date.
Also remember, for example, ABC stock spot price is 30, the day after it pays 1.5 in cash dividend. The spot price is now 28.5. If a new investor buys this stock, how much does he must pay? 30 or 28.5? He will pay 28.5 because 1.5 value was already delivered to the previous owner.
By the time the forward expiry, how much you pay? Full price or adjusted price? Adjusted for dividends.
The long must not pay more than its value and the short cannot sell it for above its value.
Price it using arbritrage. Say Spot (t=0) = $100 Dividends expected during the life time of forward contract = $10 Discount rates = 5 % Ignoring the dividends, the forward price will be 100 (1.05) = $105. Let’s assume, for now, that forward is overpriced, so we sell the forward and buy the underlying stock. Our positions at initiation (t=0): 1. Buy stock @ $100 2. Sell forward @ $105 During life time we collect dividends, since we are long: $10 At expiry (t = T) 1. Deliver the stock we are long to the short forward 2. Receive $105 So we earned the discount rate plus the dividends, without any risk. Even if dividends are not given, we are fine as there is no risk, we at least earn the discount rate. To disallow this kind of arbritrage, the forward price has to be less, so that the expected dividends are not earned by seller. If arbritrage exists, traders will start selling the forward which will eventually bring it down.
As one of the member replied, the stock value is reduced by dividend next day so technically the long to forward contract should pay the inherent value of stock and not dividend. In a way we are saying the full price of stock is composed of two parts i.e. A) some sort of inherent value of stock (which is independent of dividend) and B) the value of dividends.
So if we look at pricing of equity forward in this context (i.e. price is composed of two parts) then subtracting dividend is kind of making some sense.
So technically I am kind of okay to accpet why PV of dividend is reduced.
But as dividend discount model teaches, the entire price of stock is nothing but PV of all dividends. So if PV of dividends is something that need to subtracted then in worst case we may endup having zero stock price if forward contract is hypothetically long (very very long). Just thinking…