Futures pricing and div yield div, equity, position, afternoon, long

IAmNeil

If div growth on an equity index unexpectedly increases and I hold a short position on an index future I thought I benefited, but schweser exam 5 afternoon session says the LONG gains.

Their rationale: Higher div means index value increases and all else equal, the long gains.

My rationale: Higher div yield lowers futures prices so if I'm short the future to sell at a fixed price on a certain date my short position benfits.

A higher div yield makes futures prices lower I thought.

What do you gusy think here?? Which side of the future gains when div yields increase?

apf_jingrui_li

When it comes to futures pricing, the basic cost and carry model tells us holders of futures contract losses because of dividend yield provided by the underlying equity. However, in the case you described above, it is the unexpected dividend GROWTH RATE, which naturally reminds me of the very basic valuation principle of future cash flow discounted at stochastic discount rate, which in practice or CFA approach will be r-g, or required return minus dividend growth rate in DDM. And the  seemingly minor change in the discount factor will result in huge valuation results. Thus, in this sense, the underlying equity index will increase A LOT, long position gains.

genuinecfa

I was upset over the very same question! But I think the key word here is "growth" - dividend GROWTH increases -- think "g"

g increases, free cash flows increase, values increase.... etc.

If just dividend PAYOUT ratios increased, with no accompanying earnings growth, then you arrive at completely the opposite answer, as we both did.

I don't know whether it's fair to be upset with Schweser, or to thank them. This is exactly the kind of BS you can expect from the CFAI this Saturday.

comp_sci_kid

Key word is "unexpectedly". Expected dividends work in the way you described to reduce the price of a stock at the ex-dividend date. The receipt of these dividends has been priced in for a long time.

If a stock keeps the same payout ratio, but gets div growth through an unexpected increase in ROE, its price will increase to reflect the unexpected growth.