Impact of Dividend on futures price, depends on whether the futures contract is a cash-settled or physically settled contract.
Table of Contents
Consider the following to understand the impact of dividend on Futures price:
Dividends – Cash settled futures contracts
For cash-settled futures contracts, the impact of dividends on futures prices is generally minimal. This is because the futures contract is settled based on the difference between the futures price and the spot price at the time of expiration. Dividends do not affect the spot price of the underlying asset, and therefore do not directly impact the futures price.
Dividends – Physically settled futures contracts
For physically settled futures contracts, the impact of dividends can be more significant. In these contracts, the buyer of the futures contract is obligated to take delivery of the underlying asset at expiration.
If the underlying asset pays a dividend during the life of the futures contract, the seller of the futures contract may need to adjust the price to reflect the loss of the dividend income. Thus, this adjustment is known as the “dividend adjustment” and can lead to changes in the futures price.
In general, dividends have a downward impact on the futures price for physically settled futures contracts. This is because the value of the underlying asset declines by the amount of the dividend payment, and the futures price must be adjusted accordingly to reflect this decline in value.
Overall, the impact of dividends on futures prices will depend on the specific contract and the terms of the contract. Therefore, traders and investors should carefully consider the potential impact of dividends when trading futures contracts on individual stocks or other assets that pay dividends.
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Calculation of impact of dividend on futures price
Let’s take an example to illustrate the impact of dividends on futures prices. Suppose there is a physically settled futures contract on stock XYZ, which is trading at Rs. 1,000 per share. The futures contract has a delivery date one month from now (expiry period), and the underlying stock is expected to pay a dividend of Rs. 10 per share during the life of the futures contract i.e., within the expiry period.
Before dividend
Assuming that the risk-free interest rate is 5% per annum, the theoretical futures price can be calculated as follows:
Futures price = Spot price x (1 + rt) – d
Where: Spot price = Rs. 1,000 per share
r = 5% per annum
d = dividend yield = Rs. 10 / Rs. 1,000 = 1%
t = time to expiration in years = 1/12
Substituting the values, we get: Futures price = 1,000 x (1 + 0.05 – (1/12)) – 0.01
Futures price = Rs. 1,004.15
After dividend
Now, suppose that the stock pays the expected dividend of Rs. 10 per share during the life of the futures contract. This reduces the value of the underlying stock to Rs. 990 per share (Rs. 1,000 – Rs. 10). To reflect this decline in value, the futures price must be adjusted downwards by the same amount. The adjusted futures price can be calculated as follows:
Adjusted futures price = Futures price – (Dividend x e^(-r*t))
Where:
Futures price = Rs. 1,004.15
Dividend = Rs. 10
r = 5% per annum
t = time to expiration in years = 1/12
Substituting the values, we get:
Adjusted futures price = 1,004.15 – (10 x e^(-0.05 x 1/12)) Adjusted futures price = Rs. 994.19
Therefore, the dividend payment of Rs. 10 per share led to a decline in the futures price from Rs. 1,004.15 to Rs. 994.19. This adjustment reflects the loss of the dividend income to the seller of the futures contract, who is obligated to deliver the underlying asset at expiration.
Conclusion
It is important to be aware of the Impact of dividend on Futures price, to be successful in trading Futures.
Read: How Futures are traded and prices are determined in the market
