maryli

I agree that the short benefits from an increase in dividends, since they are holding the stock in an arbitrage-free situation.

If we have a forward price "X", maturing at time "t", the long could invest X / e^rt to have X dollars at time t.

The short could purchase the stock at price "S", and then hold it to time t to deliver the stock. These transactions must be equivalent to avoid arbitrage, so the forward price can be calculated as follows, where d is the continuous dividend yield:

X / e ^ rt = Se^(-dt), ==>

X = Se^(-dt+rt)

Now say that the dividend yield "d" is higher than originally expected. This would cause the arbitrage-free forward price "X" to be lower. So the short gains and the long loses.



Edited 1 time(s). Last edit at Friday, May 13, 2011 at 01:21PM by Binky123.

MiniMe7

It's the dividend growth rate that increases, not just a few dividends. Dividend growth rate increases is just another name for "stock value increases" so obviously the long benefits.

giants2010

Does it matter? Increase in dividend is free cash flow for short until expiration, because forward is priced to be arbitrage free at initiation.

Any increase in the stock price will benefit long at expiration, but the additional dividends paid are loss for long since they were not factored in at contract initiation and the whole point that someone is long on the stock forward would be to capture all the growth. However, the expected stock price using discount models is irrelevant in forward evaluation.

BelalM

Yes if they declare a larger dividend than expected, but your question says the dividends growth rate increased, not the pending dividend.

sameeragarwal

Think of it like this. A long is always a buyer and a short is always a seller...for any asset. So if dividends growth rate on a stock increases that will increase the intrinsic value of the stock. Since its a forward the person who owns that stock in the future will benefit from the higher valuation. If the growth rate would have been higher when the forward was priced it would have cost more to enter into the transaction.