Stock Option Contract Adjustments: The Case of Special Dividends

Available online at www.sciencedirect.
com
Journal of Financial Markets 15 (2012) 233257

www.elsevier.com/locate/nmar
Stock option contract adjustments: The case of

special dividends$
Kathryn Barraclough, Hans R. Stoll, Robert E. Whaleyn
Owen Graduate School of Management, Vanderbilt University, 401 21st Avenue South, Nashville, TN 37203, USA
Available online 20 October 2011
Abstract
The terms of stock option contracts are adjusted in the event of unexpected corporate actions, and
the nature of the adjustments may result in windfall gains or losses to open option positions. This
paper evaluates the fairness of the two different procedures used for special cash dividends. We show
that, while neither procedure is technically correct, the absolute adjustment used in the U.S. and
Canada minimizes the windfall change in option value when the dividend is announced. In addition,
the proportional adjustment used in Australia and Europe depends on stock price and is therefore
vulnerable to temporary aberrations in the stock market.
& 2011 Elsevier B.V. All rights reserved.
JEL classification: G13; G14; G15
Keywords: Stock option; Special dividend; Contract adjustment; Displaced diffusion process; Nested binomial
lattices
0. Introduction
Stock option contracts are unusual to the extent that their terms must be adjusted to
reect unexpected corporate actions. Spinoffs, cash or stock takeovers, rights issues and
special dividends are among the events that may trigger changes to the exercise price and
expiration date of outstanding option positions. The fairness of the adjustment procedures
$
The authors are grateful to Nick Bollen, Phil Gocke, David Iles, Gary Katz, Randolph Roth, Jacob Sagi, and
Tom Smith for insightful comments/discussions.
n
Corresponding author. Tel.: 1 615 343 7747.
E-mail addresses: [email protected] (K. Barraclough),
[email protected] (H.R. Stoll), [email protected] (R.E. Whaley).
1386-4181/$ - see front matter & 2011 Elsevier B.V. All rights reserved.
doi:10.1016/j.nmar.2011.10.001
234
K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257
is critical to market integrity. Neither the option buyer nor the option seller should suffer as
a result of the action. Clearing authorities guard the integrity of outstanding contracts, and
the fairness of contract adjustments for corporate actions is chief among their concerns. The
stock option clearing authority in the U.S., the Options Clearing Corporation (OCC) in its
bylaws states:
y all adjustments to the terms of outstanding cleared contracts shall be made by the
Securities Committee, which shall determine whether to make adjustments to reect
particular events in respect of an underlying interest, and the nature and extent of
any adjustment, based on its judgment as to what is appropriate for the protection of
investors and the public interest, taking into account such factors as fairness to
holder and writers (or purchasers and sellers) of affected contracts,y1
The purpose of this paper is to analyze the fairness of contract adjustment procedures
used for one particular corporate eventa special cash dividend. As it turns out, different
clearing authorities use different contract adjustment procedures. In the U.S. and Canada,
the exercise price of the option is reduced by the amount of the dividend on the ex-dividend
day. In Europe and Australia, on the other hand, the exercise price is reduced and the
number of deliverable shares is increased proportionally by the ratio of the dividend
relative to the cum-dividend stock price.
The fact that the second adjustment procedure depends on share price makes it
susceptible also to temporary aberrations in the stock market. This was made abundantly
clear recently when Altana AG, a specialty chemical company in Germany, paid a special
dividend of h33 on shares trading at about h50. Published reports suggest that the last
cum-dividend stock price was traded to an articially low level, thereby affecting contract
adjustment. When the stock price quickly returned to equilibrium levels, windfall gains
(losses) were earned (incurred) by call option buyers (sellers). Market-making rms, which
tend to be short options, bore the losses. One market-making rm reported a loss of $37
million as a result of the increased cost of covering its short position in Altana call
options.2
The outline of the rest of the paper is as follows. In the rst section, we describe in detail
the absolute and proportional contract adjustments and show that, if the underlying
stocks volatility rate does not change as a result of the special dividend, the proportional
contract adjustment produces no change in option value. The assumption that volatility
does not change is implausible, however, since the disbursement of cash must cause rms
stock return volatility to rise. In the second section, we examine the characteristics of rms
about to pay special dividends. We nd that rms generally have large known cash
balances and few investment opportunities. In the third section, we explain why standard
option valuation models fail to account for the effects of dividend payments correctly and
show how to model the effect of the cash disbursement on the stocks volatility rate using a
displaced diffusion process. In the fourth section, we use the displaced diffusion option
valuation model to determine the preferred adjustment procedure. The absolute
adjustment is shown to be fairest to both long and short option holders. In section ve,
we examine the sensitivity of the proportional contract adjustment to stock price using
1
The Options Clearing Corporation By-Laws, Adjustment Panel Policies and Procedures, Section 11 of
Article VI.
2
See Forbes.com, Interactive Brokers Cries Foul, July 6, 2007, and IBG Inc. Annual Report, 2007.
235
Altanas large special dividend in May 2007. Because the proportional adjustment depends
on the last cum-dividend stock price and the stock price appears to have been taken to an
articially low level, long (short) call option holders experienced windfall gains (losses).
The nal section contains a summary of the study and its main conclusions.
1. Adjusting for special dividends: Absolute versus proportional procedure
The terms of stock option contracts are generally not adjusted for regular cash dividend
payments. The reason is simple. Since the amount and the timing of regular dividend
payments are known or predictable, their effects on option value are known by market
participants well in advance of payment. Left unprotected, unexpected special (or
extraordinary) dividends cause unexpected changes in option value. As a result, option
exchange clearing authorities attempt to mitigate the unexpected changes in option value
by making immediate adjustments to the terms of the stock option contract. For stock
options traded on exchanges in the U.S. and Canada,3 the exercise price of the option is
reduced by the absolute amount of the special dividend on the ex-dividend day.4 We refer
to this adjustment as the absolute adjustment because it depends only on the dollar
dividend. For stock options traded on exchanges in Europe and Australia,5 two
proportional adjustments are made, both based on what is dubbed the R-factor. The
R-factor is dened as the proportion of share price that remains after the dividend is paid,
that is,
R
SD
,
S
where S is the cum-dividend stock price, and D is the amount of the special dividend. On
the ex-dividend day, (a) the exercise price is reduced by a factor of R (i.e., from X to RX),
and (b) the number of deliverable shares is increased by a factor of 1/R (e.g., if the original
number of shares deliverable on the option is 100, it is increased to 100/R)). Since this
adjustment depends on the dividend relative to the stock price, we dub it the relative or
proportional contract adjustment.
Presumably the objective of both the absolute and proportional adjustment procedures
is to leave option holders, both long and short, as well off at the instant after the special
dividend is announced as they were the instant before. Interestingly enough, except in one
special case, neither procedure is completely accurate. The one special case is where the
payment of the special dividend does not affect the underlying stocks volatility rate. For
this case, Merton (1973, p. 149, Theorem 9) shows that the proportional adjustment
procedure produces an ex-dividend option value equal to its cum-dividend level because
3
In the U.S., the clearing authority for the six options exchanges is the Options Clearing Corporation (OCC). In
Canada, all stock options trade on the Bourse de Montreal and the clearing authority is the Canadian Derivatives
Clearing Corporation (CDCC).
4
In the event that the dividend adjustment creates an exercise price that is not supported by the OCCs clearing
system (i.e., exercise prices are quoted in eighths), the amount of the dividend is added to the stock price at
expiration and no adjustment is made to the exercise price. If the special cash dividend is $11.09 per contract, for
example, the OCC will not adjust the exercise price and instead will add the cash to the deliverable at expiration.
From a valuation standpoint, the adjustment procedures produce identical results.
5
The largest stock options exchange in Europe is the Eurex, and its clearing authority is Eurex Clearing. In
Australia, the largest stock options exchange is the Australian Securities Exchange, and its clearing authority is
ACH.
236
option value is homogeneous of degree one in the stock price and exercise price, that is,
CS,X
1
CRS,RX ,
R
where C() represents the call option value as a function of the parameters included within
the parentheses. The term on the left-hand side of (2), C(S,X), is the cum-dividend value of
the call option, and the term, C(RS,RX), is the ex-dividend call option value where the
number of deliverable shares is unchanged. The factor, 1/R, increases the number of
deliverable shares. Unfortunately, this case is implausible since the disbursement of cash
from the rm cannot help but increase the stocks volatility rate. And, with increased
volatility, the proportional contract adjustment procedure will induce a windfall increase
in option value.
2. Firm characteristics when special dividends are paid
In choosing an option valuation framework that incorporates the effects of special
dividend payments on the underlying stock, we need to understand the characteristics of
rms that pay special dividends. To this end, we examine market prices, cash and shortterm investment balances, and news releases in the months surrounding the announcement
and payment of ten large special dividends during the January 2003 through December
2008 period. All of the payments were made under a regime where the OCC adjusted
contract terms only when the special dividend was large, that is, greater than or equal to
10% of the closing stock price on the declaration date. Effective February 2009,
adjustments are now made for all special dividends greater than or equal to 12.5 cents a
share. As a result, the frequency of special dividend contract adjustments has increased
dramatically.
The Appendix contains a summary of key rm characteristics for the ten large special
dividends considered. In reviewing the details, the typical situation is obvious and
intuitive.6 A rm that pays a special dividend generally (a) has a large, known cash
balance, whether accumulated through time or the sale of assets, (b) has no attractive
investment opportunities, and (c) pays the special dividend to disburse all or part of
the cash.
To illustrate, consider the rst ve special dividends (arranged in chronological order by
announcement date) of the Appendix.
Iomega: IOM announced a special dividend of $5.00 a share (43.9% of the prevailing
share price) on July 17, 2003. In the press release that accompanied IOMs dividend
announcement, the rms chairman was quoted as saying the board of directors had been
yexploring ways to improve shareholder return on the Companys excess cashy but
was unable to nd anything that met its ytwin goals of attractive returns and safety for
shareholders.
Microsoft: MFST announced a special dividend of $3 a share (10.1% of share price) on
November 9, 2004. The fact that MSFT had an excessive cash balance and was
contemplating a special dividend of more than $10 billion was reported in the Financial
Times more than a year earlier.
6
A rm can, of course, issue debt or equity to pay for a special dividend. The costs of doing so, however, are
high, so such events are rare, and, when they occur, usually involve tightly held rms.
237
Commonwealth Telephone Enterprise: CTCO announced a $13 a share special dividend

(25.7% of share price) on June 13, 2005. Nearly two years earlier, the Wall Street Journal
reported that CTCO planned to look for acquisitions to use its accumulated cash balance
over the next 1218 months, and, if they could not nd viable opportunities, would
consider share repurchases or a special dividend.
Saks: SKS announced a $4 a share special dividend (21.5% of share price) on March 6,
2006. More than 4 months earlier SKS announced the sale of its Northern Department
Store Group for $1.1 billion in cash and its intention to distribute a substantial portion of
the sale proceeds to shareholders through repurchases, a special dividend, or a
combination of both.
Great Atlantic and Pacific Tea Company: GAP announced a special dividend of $7.25 a
share (20.6% of share price) on April 4, 2006. Nine months earlier it had sold A&P Canada
for $1.2 billion in cash and $500 in shares. The subsequent special dividend was intended to
disburse part of the excess cash balance.
In summary, the story that emerges from examining rm characteristics before special
dividend payments is that the rm is known to have two parts: (a) a viable business
operation (risky assets) and (b) excessive balances in cash and/or short-term investments
(risk-free assets). Since stock return volatility is simply a market-value weighted average of
the return volatilities of these two asset categories, a special dividend announcement causes
the market-value weight assigned to risky asset return volatility and, hence, the return
volatility of the stock to rise.
3. Valuing stock options under displaced diffusion
Currently the nance literature does not have a completely satisfactory resolution on
how to value stock options on dividend-paying stocks, independent of whether the cash
dividends are regular or special. In the Black-Scholes (1973)/Merton (1973) model, for
example, dividends are ignored and the stock price is assumed to follow a smooth,
continuous process (i.e., geometric Brownian motion). Such a process does not permit
discrete cash dividend payment schedules typically observed for common stock. Roll
(1977) circumvents the problem by assuming that the stock price, net of the present value
of the promised dividends, follows geometric Brownian motion. In doing so, he is able to
derive an analytical formula for valuing an American-style call option on a dividendpaying stock.7 The assumption, however, introduces a logical inconsistencytwo options
with different numbers of dividends paid during their lives will have different stock price
processes. Indeed, in the extreme case of perpetual options, the volatility rate must fall to
zero.8
3.1. Valuing European-style options
Interestingly enough, a more satisfactory, but largely overlooked, stock price process
exists for modeling the effects of discrete cash dividendsthe displaced diffusion process.
Rubinstein (1983) is the rst to recognize the practical signicance of displaced diffusion in
stock option valuation and derives valuation formulas for European-style calls and puts.
7
8
Whaley (1981) corrects a misspecication in the original Roll (1977) formula.

This follows since the stock price is the present value of a known cash dividend stream.
238
His key assumption is that the rm has two assets: a risky asset with current value A (i.e.,
the market value of the assets driving the rm as an ongoing business concern) and a riskfree asset with current value CASH (i.e., the cash and short-term investment balances).
Changes in the risky asset price are assumed to follow geometric Brownian motion with a
constant volatility rate sA. If the rm is nanced entirely with common stock, the stock
price process is SACASH, hence the name displaced diffusion. Proportion a(A/S)
of the rms asset structure is the risky asset and 1a(CASH/S) is in risk-free interestbearing cash. In the absence of dividends, the stock price at future time T is
~
S~ T AeR A T CASHerT
~
SaeR A T 1aerT ,
~ A is the risky asset return and r is the risk-free interest rate. Under the assumption
where R
that the rms risky assets are tradable,9 the current value of a European-style call option is
C aSNd1 XerT S1aNd2 ,
where X is the exercise price of the option,

d1
lnaS=XerT S1a 0:5s2A T

p
,
sA T
p
and d2 d1 sA T :
3.2. Valuing American-style options

To value American-style options under the displaced diffusion assumption, an
approximation method such as the Cox-Ross-Rubinstein (1979) (hereafter CRR) binomial
method must be used. Since the risky asset, not the stock price, is the underlying source of
uncertainty, the price lattice in the binomial
procedure is for the risky asset. The up-step
p
and down-step coefcients are u esA Dt and d1/u, respectively,
p and the up-step and
down-step probabilities are pu 1=2 1=2r0:5s2A =sA Dt and pd1pu, respectively, where sA is the volatility rate of the risky asset and Dt is the user-dened time
increment.10 Based on the risky asset price lattice, a stock price lattice is then developed. At
the options expiration, the stock price at each node equals the sum of the risky asset price
at the node and the terminal value of the risk-free asset, CASHerT. The option value at
each terminal stock price node (t T) is then computed using:
Cti max0,Sti X ,
where Sti is the stock price at node i of time t. The remaining steps for valuing Americanstyle options using the binomial method are the same as in the standard model.11 The
option values for the nodes in the preceding time steps are computed by taking the present
value of the expected future value, that is,
i1
i
Cti er Dt pu Ct1
pd Ct1
:
9
The assumption that risky assets are tradable is reasonable since the rms observed share price is simply the
sum of the price per share of the underlying business concern and the price per share of the idle cash balance.
10
The options time remaining to expiration T is divided into n discrete time increments, with each increment
dened as DtT/n.
11
For an explanation and a numerical example, see Whaley (2006, pp. 304312).
239
If the exercise proceeds are higher at that node, the option holder is assumed to rationally
exercise the option immediately since it is worth more dead than alive.
3.3. Incorporating regular cash dividends
To introduce regular cash dividends into the displaced diffusion binomial option
valuation procedure, we assume that the amount and the timing of the dividend payments
made during the options life are known and that the present value of the dividends is less
than or equal to the amount of cash (i.e., the risk-free asset) in the rm,12 that is,
PVD
nD
X
Di erti rCASH,
i1
where Di is the amount of the ith dividend to be paid at time ti, and nD is the number of
dividends paid during the options life. At the end of the options life, the value of risk-free
assets remaining within the rm is
CASH erT
nD
X
Di erTti :
i1
This amount gets added to each risky asset price node at time T to determine the
corresponding stock price (in place of CASHerT that was added to the risky asset price
node when no dividends are paid). As the binomial procedure steps backward in time, the
value of the original risk-free cash (the rst term in (8)) and the future value of the
dividends (the second term in (8)) are reduced by a factor of er Dt. Note that, if the ith
dividend is paid after the current time step, it is not included in the second term of (8). By
the time the binomial procedure returns to the current date, expression (8) equals the
original amount of cash. All other steps in the binomial procedure are the same as before.
Table 1 illustrates the effects of dividend payments on the values of European- and
American-style call and put options. Two dividend assumptions are made. In the rst, a single
dividend of 2 is paid in 60 days, and, in the second, two dividends of 2 are paid in 15 and in
105 days. Rubinsteins (1983) formulas are used to compute the European-style call and put
option values. In the one-dividend scenario, the present value of the dividend, 1.984, is
subtracted from the value of the risk-free asset, so the stock price becomes 48.016 and the
proportion of the rm in risky assets becomes a 45/48.016 0.937. Note that the stocks
volatility rate rises from 36% in the no-dividend case to 37.5% in the one-dividend case. The
payment of the cash dividends makes the stock riskier, as expected. In the two-dividend
scenario, the present value of the dividends is 3.967, the stock price is 46.033, the proportion
of the rm in risky assets is a 0.978, and the stocks volatility rate is 39.1%.
12
Within this framework, paying the dividend from cash implies that the stock price falls by the amount of the
dividend on ex-dividend day. The validity of this assumption has been examined empirically. Early studies of the
stock price behavior on ex-dividend days date generally nd that the stock price decline is smaller than the amount
of the dividend. Campbell and Beranek (1955), for example, nd an average decline of 90% of the dividend, which
they attribute to the preferential tax treatment of capital gains vis-a-vis dividend income. Durand and May (1960)
report an average value of 96%, and Elton and Gruber (1970) report 78%. In more recent work, Graham,
Michaely, and Roberts (2003) show that since the introduction of decimal pricing and reduced tax rate
differentials, the ratio has moved closer to one. Barone-Adesi and Whaley (1986) show that the stock price decline
implied by option prices on dividend-paying stocks is not different from one from a statistical standpoint.
240
Table 1
Simulated values of European- and American-style call and put options using the displaced diffusion option
valuation model.
Stock price is 50, risk-free interest rate is 5%, a is 0.9, and volatility rate of risky asset is 40%. The options are
assumed to have 120 days remaining to expiration. Two dividend assumptions are: (a) one dividend of 2 in 60
days, and (b) two dividends of 2 in 15 and 105 days. European-style values are computed using analytical formulas
and American-style values are computed using binomial method.
Call Option Value
One Dividend
Put Option Value
Two Dividends
One Dividend
Two Dividends
Exercise Price
European
American
European
American
European
American
European
American
40
42
44
46
48
50
52
54
56
58
60
9.541
8.050
6.705
5.516
4.484
3.603
2.865
2.255
1.758
1.359
1.042
10.588
8.877
7.327
5.952
4.768
3.783
2.971
2.316
1.793
1.380
1.055
8.038
6.695
5.507
4.476
3.597
2.859
2.250
1.754
1.356
1.040
0.792
10.119
8.270
6.665
5.329
4.242
3.358
2.634
2.047
1.577
1.204
0.911
0.873
1.348
1.971
2.750
3.685
4.772
6.001
7.358
8.829
10.397
12.048
0.886
1.372
2.004
2.793
3.744
4.854
6.112
7.505
9.015
10.626
12.320
1.353
1.977
2.757
3.693
4.781
6.011
7.370
8.841
10.410
12.062
13.781
1.369
1.996
2.777
3.716
4.813
6.051
7.419
8.904
10.486
12.148
13.876
In Table 1, both the American-style call and the put options have sizable early exercise
premiums. The value of the European-style call with a 40 exercise price, for example, is
9.541 while the corresponding American-style call value is 10.588. The difference in value,
1.047, is the early exercise premium. In the presence of cash dividends, the call may
optimally be exercised early just prior to the ex-dividend date. Note that the value of the 40
American-style call is 11.179 with no dividends, 10.588 with one dividend, and 10.119 with
two dividends. The greater the amount of cash paid out by the rm, the lower the call
option value. The effect of dividend payments on the value of the put is just the opposite.
4. Determining fairest special dividend contract adjustment

We now turn to analyzing the valuation effects of the special dividend contract
adjustments. In the event that a rm announces a special dividend on a stock whose options
trade in a U.S. or Canadian option market, the respective clearing corporations reduce the
exercise price of the option by the absolute amount of the special dividend on the ex-dividend
day. In European and Australian option markets, the authorities reduce the contract exercise
price and increase the number of deliverable shares proportionally by the ratio (1).
It is straightforward to value a stock option under the absolute contract adjustment
procedure. Assuming the amount and the timing of the special dividend have been
announced, Eq. (5) is used as the early exercise boundary condition for all call option
nodes before the ex-dividend day, and the early exercise boundary condition,
Cti max0,Sti X D,
241
is used for all option nodes on and after the ex-dividend day. Note that in (9) the exercise
price is reduced by the amount of the dividend, as is prescribed by the option clearing
corporations in the U.S. and Canada.
The modication to the binomial option valuation framework for the proportional
contract adjustment procedure is more complicated. The reason is that the R-factor used to
adjust the terms of the option contract on the ex-dividend day depends on the stock price.
Consequently, in valuing the option, we cannot begin at the options expiration and work
backwards since we do not know what particular contract adjustment is made on the exdividend day. Instead, we develop the risky asset price and stock price lattice only through
the ex-dividend day. At the ex-dividend instant, we know all of the nodal stock prices. At
each node, we compute the R-factor using equation (1) and adjust the exercise price to a
level of RX. Once we do so, we value the option at that node by applying the binomial
procedure, where the option has an exercise price of RX and a time to expiration equal to
the time between the ex-dividend day and the expiration date. This computed option value
is then scaled by 1/R, to complete the adjustment as prescribed by the clearing
corporations in Europe and Australia. In other words, we nest binomial option valuation
lattices within a binomial option valuation lattice to value the option nodes on the exdividend day.13 We then proceed backward in time from the ex-dividend day using the
standard binomial option valuation mechanics.
Table 2 contains simulation results. The column headed Pre-announcement contains
option values before the market becomes aware that a special dividend is about to be
declared. The next three columns make the assumption that a special dividend of 5 has just
been announced and will be paid in one day. The column headed No adjustment contains
the option values assuming the options are unprotected, as is the case for regular cash
dividends. For the call with an exercise price of 40, the option value is 10, exactly equal to
the exercise proceeds. This implies that the call should be exercised immediately before the
stock goes ex-dividend. The calls with exercise prices of 42 and 44, likewise, should be
exercised immediately since they are trading at their intrinsic values. The drop in value
from the pre-announcement level reects the fact that, with no contract adjustment for the
surprise dividend, call options experience a windfall loss in value. Conversely, unprotected
put options experience a windfall increase.
Recall that the purpose of the contract adjustments is to preserve the value of the option
in light of the unexpected special dividend announcement. The absolute adjustment
attempts to do this by reducing the exercise price by the amount of the dividend, and the
proportional adjustment attempts to do this by multiplying the stock price and the exercise
price by the R-factor and scaling the option position up by a factor of 1/R. The Absolute
Adjustment column in Table 2 contains the ex-dividend option values for the absolute
adjustment, and the Proportional Adjustment column contains the ex-dividend option
values for the proportional adjustment. Subtracting the cum-dividend option values from
the ex-dividend levels of the absolute and proportional adjustment procedures produces
the windfall changes in option value shown in the two right-most columns of the table. The
40-exercise price call option, for example, has a windfall value change of 0.071 using the
absolute contract adjustment procedure while the proportional adjustment has a windfall
value change of 0.249. In general, across the call and put option series considered in the
13
Fleming and Whaley (1994) use a similar technique to value the wildcard option embedded in the Americanstyle S&P 100 index options.
242
Table 2
Simulated values of American-style call and put options using the displaced diffusion option valuation model.
Stock price is 50, risk-free interest rate is 5%, a is 0.9, and volatility rate of risky asset is 40%. The options are
assumed to have 120 days remaining to expiration. The rm is assumed to have just announced that a special
dividend of 5 is to be paid in one day. Option values computed using binomial method.
Panel A. Call Option values
Post-announcement
Exercise
Price
40
42
44
46
48
50
52
54
56
58
60
PreNo
announcement Adjustment
11.176
9.556
8.067
6.719
5.524
4.486
3.601
2.862
2.253
1.760
1.363
10.000
8.000
6.000
4.005
3.201
2.532
1.983
1.538
1.181
0.896
0.681
Windfall Value Change
Absolute
Adjustment
Proportional
Adjustment
Absolute
Adjustment
Proportional
Adjustment
11.105
9.493
8.008
6.666
5.476
4.444
3.571
2.836
2.228
1.740
1.348
11.425
9.863
8.426
7.126
5.966
4.946
4.063
3.308
2.672
2.141
1.702
0.071
0.063
0.059
0.053
0.048
0.042
0.031
0.026
0.025
0.020
0.016
0.249
0.307
0.360
0.407
0.441
0.460
0.462
0.447
0.418
0.381
0.339
Panel B. Put Option Values

Post-announcement
Exercise
Price
40
42
44
46
48
50
52
54
56
58
60
PreNo
announcement Adjustment
0.530
0.884
1.369
2.001
2.790
3.743
4.856
6.121
7.524
9.052
10.687
1.685
2.407
3.288
4.328
5.521
6.856
8.320
9.897
11.572
13.331
15.167
Windfall Value Change
Absolute
Adjustment
Proportional
Adjustment
Absolute
Adjustment
Proportional
Adjustment
0.540
0.900
1.389
2.024
2.817
3.774
4.894
6.160
7.561
9.088
10.721
0.781
1.192
1.731
2.410
3.232
4.201
5.311
6.555
7.924
9.407
10.990
0.010
0.016
0.020
0.024
0.027
0.032
0.038
0.039
0.036
0.035
0.033
0.251
0.309
0.362
0.409
0.442
0.458
0.454
0.434
0.400
0.355
0.303
table, the absolute contract adjustment procedure produces changes that are uniformly
lower in absolute value than those of the proportional contract adjustment procedure, the
absolute adjustment produces slightly lower (higher) values for call (put) options, and the
proportional contract adjustment produces relatively large increases in value for both call
and puts options.
The results of the simulations provided in Table 2 are sensitive to the parameter
assumptions. While the absolute contract adjustment appears to work best in Table 2, this
result may not hold across broad ranges of valuation parameters such as the volatility rate,
the time remaining to expiration, and the proportion of the rm in risky assets. For this
reason, we now to turn to simulating value changes using realistic parameter ranges.
243
Table 3
Summary of special dividends greater than or equal to 12.5 cents per share from January 1996 to December 2008.
Number of special dividends appearing in the CRSP distribution le is 1,055. Of these, 322 are less than 12.5
cents. The remaining 733 special dividends are summarized below.
Average
Decile
No.
Dividend
Amount
Share
Price
Dividend
Yield
No. of
Days
Implied Share
Price
1
2
3
4
5
6
7
8
9
10
74
73
73
73
73
74
73
73
73
74
0.2534
0.4535
0.5723
0.6426
1.0433
1.6264
1.7744
3.4152
5.3003
7.2983
52.46
41.16
32.20
27.81
30.52
32.05
20.64
23.58
21.26
14.49
0.0056
0.0108
0.0177
0.0233
0.0347
0.0517
0.0865
0.1476
0.2491
0.5745
12.82
16.93
13.18
12.33
13.48
14.61
14.86
15.70
22.71
32.31
45.65
41.82
32.27
27.57
30.07
31.46
20.52
23.14
21.28
12.70
All
733
2.2413
29.63
0.1205
16.91
18.60
The most sensible place to begin is to develop an understanding of the typical size of
special dividends paid in the U.S. Table 3 provides summary results. The numbers in the
table are based on all special dividends appearing in the CRSP distribution le during the
January 1996 through December 2008 period. In total, 1,055 special dividends appear in
the le. Of these, 322 are less than 12.5 cents and are eliminated. The average special
dividend amount across the 733 remaining special dividends (about 56 a year) is 2.2413,
and the average share price is 29.63. Because we need the share price corresponding to a
typical dividend, we compute the average dividend yield, and then infer the typical share
price by multiplying the average dividend by the inverse of dividend yield. The average
dividend yield is 0.1205, which means the implied stock price corresponding to the average
dividend is 18.60. We now use these parameter estimates in a series of simulations.
Table 4 contains simulation results for a range of risky asset return volatility rate
assumptions. The stock price is set equal to 18.60, and the proportion of the rm invested
in risky assets is a (18.602.2413)/18.60 0.8795. The stock is assumed to go ex-dividend
(i.e., the special dividend of 2.2413) in 17 days. Panel A contains the option values just
before the special dividend announcement is made. Panels B and C contain the percentage
windfall changes in value resulting from the absolute and proportional contract
adjustment procedures, respectively. The percentage changes are revealing. For the
absolute adjustment, call option values fall and put option values rise, albeit by a small
amount. The largest value change is 1.90% for the 22.5 call at a volatility rate of 30%.
For the proportional contract adjustment, the percentage windfall value changes are
uniformly in the favor of the option buyer. The holder of the 22.5 call whose underlying
risky asset return volatility is 30% increases in value by 36.49%.
Over the range of volatility rate assumptions considered, Table 4 shows: (a) the absolute
contract adjustment procedure produces the lowest percentage changes in an absolute
sense, (b) under the absolute contract adjustment, call option values fall slightly and put
option values rise slightly, and (c) the proportional adjustment produces relatively large
244
Table 4
Stock price is 18.60, risk-free interest rate is 5%, and a is 0.8795. The options are assumed to have 120 days
remaining to expiration. The rm is assumed to have just announced that a special dividend of 2.2413 is to be paid
in 17 days. Option values computed using binomial method.
Panel A. Pre-announcement Option Values
Call Option Exercise Prices
Put Option Exercise Prices
Volatility Rate
17.5
20
22.5
17.5
20
22.5
30%
40%
50%
60%
70%
80%
90%
100%
1.906
2.229
2.565
2.902
3.239
3.586
3.931
4.273
0.701
1.063
1.439
1.812
2.181
2.552
2.928
3.301
0.197
0.449
0.754
1.096
1.444
1.815
2.182
2.545
0.533
0.859
1.196
1.534
1.874
2.221
2.567
2.910
1.837
2.187
2.557
2.927
3.295
3.665
4.040
4.413
3.921
4.106
4.382
4.708
5.047
5.412
5.775
6.137
Panel B. Absolute Contract Adjustment

Volatility Rate
17.5
20
22.5
17.5
20
22.5
30%
40%
50%
60%
70%
80%
90%
100%
1.12%
0.83%
0.70%
0.60%
0.46%
0.40%
0.36%
0.32%
1.46%
1.11%
0.78%
0.60%
0.48%
0.48%
0.40%
0.34%
1.90%
1.03%
0.76%
0.64%
0.58%
0.45%
0.36%
0.29%
1.55%
1.22%
0.91%
0.73%
0.72%
0.62%
0.55%
0.49%
0.67%
0.58%
0.55%
0.51%
0.47%
0.39%
0.36%
0.34%
0.10%
0.26%
0.31%
0.31%
0.29%
0.29%
0.28%
0.27%
Panel C. Proportional Contract Adjustment

Volatility Rate
17.5
20
22.5
17.5
20
22.5
30%
40%
50%
60%
70%
80%
90%
100%
6.24%
7.35%
8.22%
9.03%
9.63%
9.81%
9.95%
10.08%
17.28%
16.33%
14.56%
14.30%
14.23%
13.98%
13.49%
13.13%
36.49%
28.84%
24.16%
20.44%
19.27%
17.18%
16.86%
16.68%
22.40%
19.06%
17.63%
17.05%
16.56%
15.76%
15.18%
14.74%
6.18%
7.65%
8.04%
8.69%
9.27%
9.63%
9.70%
9.76%
0.95%
2.62%
3.81%
4.53%
5.34%
5.64%
6.24%
6.79%
windfall increases in the values of both call and put options. Table 5 contains percentage
windfall changes in value using different numbers of days to expiration, and Table 6
contains percentage windfall changes in value using different numbers of days to
expiration and levels of a. The results are qualitatively similar to those of Table 4.
In summary, the results reported in Tables 46 appear robust. While neither contract
adjustment procedure is completely accurate from a fairness standpoint, the absolute
245
Table 5
Stock price is 18.60, risk-free interest rate is 5%, a is 0.8795, and the volatility rate is 50%. The rm is assumed
to have just announced that a special dividend of 2.2413 is to be paid in 17 days. Option values computed using
binomial method.
Days to Expiration
17.5
20
22.5
17.5
20
22.5
30
60
90
120
150
180
210
240
1.606
1.986
2.298
2.565
2.803
3.019
3.220
3.408
0.451
0.840
1.159
1.439
1.689
1.916
2.127
2.325
0.083
0.300
0.533
0.754
0.976
1.181
1.371
1.563
0.437
0.749
0.995
1.196
1.369
1.522
1.660
1.787
1.782
2.100
2.348
2.557
2.737
2.896
3.039
3.170
3.934
4.075
4.234
4.382
4.528
4.661
4.780
4.898

Days to Expiration
17.5
20
22.5
17.5
20
22.5
30
60
90
120
150
180
210
240
0.16%
0.39%
0.56%
0.70%
0.82%
0.93%
1.02%
0.98%
0.22%
0.47%
0.70%
0.78%
0.85%
0.91%
0.96%
1.00%
0.27%
0.63%
0.77%
0.76%
0.96%
0.95%
0.96%
1.21%
0.24%
0.60%
0.77%
0.91%
1.02%
1.12%
1.23%
1.52%
0.08%
0.28%
0.41%
0.55%
0.67%
0.78%
0.88%
0.98%
0.01%
0.10%
0.20%
0.31%
0.38%
0.47%
0.55%
0.58%

Days to Expiration
17.5
20
22.5
17.5
20
22.5
30
60
90
120
150
180
210
240
3.21%
6.36%
7.44%
8.22%
8.78%
9.18%
9.50%
9.77%
11.16%
14.66%
15.02%
14.56%
14.65%
14.61%
14.58%
14.54%
23.61%
26.78%
24.66%
24.16%
21.77%
20.93%
20.74%
19.67%
11.71%
16.77%
17.16%
17.63%
17.96%
18.19%
18.38%
18.54%
2.67%
5.69%
7.25%
8.04%
8.84%
9.45%
9.96%
10.39%
0.34%
1.70%
2.81%
3.81%
4.37%
4.95%
5.54%
5.89%
contract adjustment produces the smallest absolute changes in option value when a special
dividend is announced. For the parameter ranges considered, the relative absolute change
in value never exceeded 2%. The proportional contract adjustment, on the other hand,
leads to windfall increases in the values of both calls and puts as a result of the stock return
volatility increase implied by the announcement of the special dividend payment. The size
246
Table 6
Stock price is 18.60, risk-free interest rate is 5%, and volatility rate is 50%. The options are assumed to have 120
days remaining to expiration. The rm is assumed to have just announced that a special dividend of 2.2413 is to be
paid in 17 days. Option values computed using binomial method.
Alpha
17.5
20
22.5
17.5
0.8795
0.8295
0.7795
0.7295
0.6795
0.6295
0.5795
0.5295
2.565
2.464
2.364
2.263
2.163
2.066
1.972
1.879
1.439
1.336
1.232
1.128
1.024
0.920
0.822
0.724
0.754
0.675
0.595
0.516
0.437
0.369
0.301
0.238
1.196
1.095
0.994
0.894
0.793
0.695
0.601
0.507

20
22.5
2.557
2.455
2.353
2.252
2.151
2.051
1.956
1.862
4.382
4.308
4.235
4.165
4.098
4.042
3.989
3.947
Alpha
17.5
20
22.5
17.5
20
22.5
0.8795
0.8295
0.7795
0.7295
0.6795
0.6295
0.5795
0.5295
0.70%
0.73%
0.76%
0.80%
0.83%
0.98%
1.02%
1.07%
0.78%
0.84%
0.91%
1.00%
1.10%
1.04%
1.12%
1.27%
0.76%
0.85%
0.96%
1.11%
0.99%
1.17%
1.43%
1.34%
0.91%
0.99%
1.09%
1.22%
1.37%
1.30%
1.50%
1.79%
0.55%
0.56%
0.57%
0.59%
0.60%
0.67%
0.69%
0.69%
0.31%
0.30%
0.29%
0.26%
0.26%
0.23%
0.19%
0.15%

Alpha
17.5
20
22.5
17.5
20
22.5
0.8795
0.8295
0.7795
0.7295
0.6795
0.6295
0.5795
0.5295
8.22%
7.94%
7.70%
7.54%
7.45%
7.18%
6.67%
6.14%
14.56%
14.80%
15.15%
15.62%
16.21%
16.93%
17.08%
17.22%
24.16%
24.33%
24.56%
25.78%
28.57%
28.87%
30.21%
33.76%
17.63%
17.89%
18.29%
19.05%
20.22%
21.31%
21.95%
22.85%
8.04%
7.88%
7.74%
7.60%
7.43%
7.22%
6.76%
6.24%
3.81%
3.44%
3.07%
2.78%
2.52%
2.07%
1.66%
1.26%
of the relative increases depends on the valuation parameters but can exceed 30%. The
proportional adjustment is unambiguously detrimental to option sellers.
5. Analyzing Altanas contract adjustment
The valuation analyses conducted in the previous section show that, of the two special
dividend contract adjustment procedures, the absolute adjustment is fairest to option
247
holders in the sense that option values are relatively unaffected by the special dividend
announcement. As a postscript to our analysis, we describe another potential problem with
using the proportional adjustmentits sensitivity to stock price. To do so, we use the
controversy surrounding Altana AGs special dividend on May 4, 2007.
Altana AG is a developer and producer of innovative, high-quality products in the
specialty chemicals industry. In 2006, Altana AG also owned a large pharmaceuticals
subsidiary, Altana Pharma. In August 2006, the Danish drugmaker, Nycomed, expressed
publicly an interest in buying Altana Pharma.14 By the end of the year, the deal was
consummated. Altana AG had accepted Nycomeds h4.5 billion cash offer. For the rst
few months of 2007, the funds were held as cash and marketable securities. On March 13,
2007, Altana AGs supervisory board approved a proposal to distribute the funds in the
form of a special dividend of h33 per share. In addition, the board also approved a
proposal for a regular dividend of h1.30 and a bonus dividend of h0.50. On May 3, 2007,
the shareholders of Altana AG approved the supervisory boards proposals and the stock
went ex-dividend on May 4, 2007. The total dividend payment amounted to h4,732
million, or 74.74% of the market value of the Altanas stock at the time.
We focus on the alleged manipulation of Altanas share price on May 3, 2007. Fig. 1 shows
daily closing prices from March 16 to June 19, 200730 trading days before the last cumdividend day through 30 days after May 3, 2007 the last cum-dividend day (denoted day 0).
In Fig. 1, the stock prices before and including trading day 0 are closing cum-dividend
closing prices as the dividend has not yet been paid (i.e., the impending h34.80 dividend
payment remains impounded in the stock price). The stock prices after day 0 are also cumdividend prices as h34.80 is added to the daily closing prices. The price plot is compelling.
Before the ex-dividend day, the stock price rises slowly and smoothly, reaching a level of
h54.49 two days before the last cum-dividend day (April 30 or day 2). Then, inexplicably, it
drops to h51.82 on the next day (day 1) and to h46.56 at the close on the last cum-dividend
day (day 0)a drop of nearly 15% over two days. On ex-dividend day (day 1), the stock price
rebounds to h54.60, and to h57.19 a day lateran increase of nearly 23%. It then reverses to
close at what appears to be a more normal level, h54.40, on day 3 or May 8. Note that the
stock price move from the day 2 to day 3 is h54.49 to h54.40 (or, in terms of actual prices,
from h54.49 to h19.60 where a dividend of h34.80 has been paid)almost exactly as it should
be in an efciently-functioning marketplace.15 The pattern of prices for Altana in the days
immediately surrounding the ex-dividend day appear abnormal. In particular, the closing
price on the last cum-dividend day (day 0) appears dramatically below its equilibrium level.
To understand the effect of the stock price distortion on Altanas stock options, recall
the denition of the R-factor (1). In the case of Altana AG on May 3, 2007, three dividends
are about to be paid simultaneously: a regular dividend, a special dividend, and a bonus
dividend. The special and bonus dividends affect the R-factor as follows:
R
Scumdividend Dregular Dspecial Dbonus

,
Scumdividend Dregular
10
where Scumdividend is the stock price at the close on the day before ex-dividend. Although the
dividend amounts in (10) are known, the R-factor is sensitive to the level of the cum-dividend
14
See Pharma Marketletter, August 1, 2006.

Recall that, in footnote 13, we discussed the empirical evidence regarding ex-dividend stock price drops in the
U.S. In recent years, the price drop has not been signicantly different from the amount of the cash dividend.
15
248
60
55
Stock price
50
45
40
35
30
-30
-20
-10
10
20
30
No. of days from last cum-dividend day

Fig. 1. Altana stock price in 30 calendar days before and after the last cum-dividend day, May 3, 2007. All stock
prices are cum-dividend. Stock prices before and including day 0 are actual cum-dividend prices, while stock
prices after day 0 are actual prices plus h34.80 (i.e., the sum of the regular dividend of h1.30, the bonus dividend of
h0.50, and the special dividend of h33).
stock price Scumdividend. As noted above, the stock price fell by more than h5 on May 3, the
last cum-dividend day.
Measuring precisely the economic consequences of the Altana stock price reversal
in the option market is subjective in the sense that we need to specify Altanas true
stock price as of the close on May 3, 2007. In Fig. 1, several alternatives are discernible.
One possibility is to use the previous days (day 1) closing price, h51.82. But, this
may be too low since the stock price fell dramatically on the previous day.
A second possibility is to use the day 2 stock price, h54.49, but this may be too high
since the stock had recently run up in price. A third possibility is the stock price in the
aftermath of the stock going ex-dividend. The average daily closing stock price over the
30-trading day from May 8 to June 19, 2007, for example, is h18.72. Adding the
h34.80 in cash dividends to this average share price, the cum-dividend stock price is
h53.52. For illustrative purposes, we use this estimate and assume that the true
stock price is h53.52 as of the close on May 3 and that the actual, but distorted price is
h46.56.
In measuring the economic consequences, we also need to specify the terms of the stock
option contracts before the dividend, the risk-free interest rate, the ratio of the value of
risky assets to the market value of the stocks equity a, and the risky asset return volatility
rate sA. To represent typical contract terms, we use Altanas nearby options, which expire
on May 18, 2007. On the last cum-dividend day, these options have 15 days to expiration.
The risk-free interest rate based on the 15-day ECU euro rate is 3.89%. To measure a, we
turn to Altanas nancial statements as of March 31, 2007. At the time, the sum of cash
and marketable securities was h4,766 million, and the number of shares outstanding was
135,987,000. Our estimate of cash per share on May 3, 2007 is, therefore, h35. Dividing the
cash by the estimated equilibrium share price, h53.52, and subtracting from one, the level
of a is 0.3460.
249
Finally, to estimate the volatility of the risky assets, we use the relation between the
instantaneous volatility rates of the rms risky assets and its stock, sA sS/a. To estimate
the stocks volatility rate, we use the 83 daily returns from the beginning of January 2007
(when the divestiture of Altana Pharma was complete) through the end of April (before the
abnormal price movements in the days surrounding the special dividend) and nd that the
annualized stock return volatility rate is 11.33%. At a level a .3460, the risky asset return
volatility rate is 32.75%.16
Table 7 contains the simulated option values of the call and put options as of the close of
trading on the ex-dividend day. Three separate cases are shown: (a) no distortion, (b) with
distortion, and (c) with distortion and reversal. Under the columns headed No
distortion, the assumption is that the share price closed at its true level, 53.52, on the
last cum-dividend day and remained at that level at the close on the ex-dividend day. With
the stock price at 53.52, the R-factor for option adjustment is
Rtrue
53:521:3033:00 0:50
0:3585:
53:521:30
All open option exercise prices are adjusted from their existing levels by a factor of
0.3585. The call and puts options with an original exercise price of h30, for example, have
their exercise price adjusted to h30 0.3585 10.75. At the same time, the number of
shares of each option contract increases by a factor of 1/R 2.7895. With the original
contract denomination of 100 shares, the ex-dividend contract denomination becomes
278.95 shares. Under the assumption that the stock price does not change from the close
on the last cum-dividend to the close on the ex-dividend day, the close on the ex-dividend
day is h18.72, that is, h53.52 less the regular dividend of h1.30, the bonus dividend of
h0.50, and the special dividend of h33.00. Note that, where the cash per share was h35
before the dividend payments, it falls to h0.20 on the ex-dividend day. Where the level of a
is 0.3460 before the dividend payment, it rises to 0.9893 after the dividend payment. With
the disbursement of cash, risky assets become a higher proportion of total assets. All of
these gures are summarized in the panel immediately below the heading No distortion.
Panels B and C in Table 7 contain call and put option values, respectively. To interpret
the entries in these panels, consider the 30-call. The rst column is the original exercise
price. The Adjusted Exercise Price column is the exercise price after the contract
adjustment. With an R-factor of 0.3460, the adjusted price is h10.75. The next column is
the option value per share as of the close of trading on ex-dividend day (14 days to
expiration). The stock price is h18.72, and the risk-free rate and the risky asset return
volatility rate remain at 3.89% and 32.75%, respectively. The ex-dividend level of a is
0.9893, as noted above, and there are no dividends paid during the options remaining life.
The value per share is h7.982, and, since the option now has a denomination of 278.95
shares, the contract value is h2,226.47.
In Table 7, under the columns headed With distortion, the assumption is that the
share price closed at an articially low level of h46.56 on the last cum-dividend day and
remained at this articially low level at the close on the ex-dividend day. The panel
immediately below the heading summarizes the changes in stock price-related parameters.
The stock price falls from h46.56 on the cum-dividend day to h11.76 on the ex-dividend
16
Interestingly, during the 83 trading days after the stock went ex-dividend window (May 8September 4, 2007),
Altana had an estimated realized stock return volatility rate of 28.41%, very close to the assumed level of 32.75%.
250
Panel A. Market Parameters

No distortion: Stock price at
true value on cum-dividend
day and remains there on
ex-dividend day.
Stock Price
Cash
Risky Assets
Alpha
R-factor
1/R
No. of Shares
Cum-dividend
Ex-dividend
53.52
35.00
18.52
0.3460
18.72
0.20
18.52
0.9893
0.3585
2.7895
278.95
100
With distortion: Stock price 6.96

below true value on cum-dividend
day and remains there on
ex-dividend day.
With distortion and reversal:

Stock price 6.96 below true value on
cum-dividend day and reverses to true
value on ex-dividend day.
Cum-dividend
Ex-dividend
46.56
35.00
11.56
0.2483
100
Ex-dividend
11.76
0.20
11.56
0.9830
0.2598
3.8486
384.86
18.72
0.20
18.52
0.9893
0.2598
3.8486
384.86
Panel B. Call Option Values

Gains from distortion
Original
Exercise
Price
Adjusted
Exercise
Price
Option
Value
Per Share
Contract
Value
Original
Exercise
Price
Adjusted
Exercise
Price
Option
value
Per Share
Contract
Value
Option
Value
Per Share
Contract
Value
Contract
Revision
Revision
Plus Stock
Price Move
30
35
40
45
50
55
10.75
12.55
14.34
16.13
17.92
19.72
7.982
6.192
4.402
2.615
0.987
0.147
2,226.47
1,727.21
1,227.96
729.56
275.46
41.11
30
35
40
45
50
55
7.79
9.09
10.39
11.69
12.99
14.29
3.977
2.679
1.388
0.340
0.020
0.000
1,530.47
1,031.21
534.19
130.92
7.77
0.08
10.937
9.639
8.342
7.045
5.748
4.451
4,209.12
3,709.86
3,210.61
2,711.35
2,212.10
1,712.84
1,982.65
1,982.65
1,982.65
1,981.79
1,936.63
1,671.74
2,678.65
2,678.65
2,676.42
2,580.43
2,204.33
1,712.77
Table 7
Simulated values of Altana call and put options on ex-dividend day.
Binomial implementation of displaced diffusion option valuation model is used to value options. True cum-dividend stock price is h53.32 on last cum-dividend day.
The actual, but distorted stock price is h46.56. The risk-free interest rate is 3.89%, the cum-dividend a is 0.3460, and the risky asset return volatility rate is 32.75%.
The options have 15 days remaining to expiration. A special dividend of h33.50 and a regular dividend of h1.30 have just been paid.
60
65
21.51
23.30
0.007
0.000
1.86
0.02
60
65
15.59
16.89
0.000
0.000
0.00
0.00
3.154
1.879
1,213.77
723.31
1,211.91
723.29
1,213.77
723.31
Panel C. Put Option Values

Gains from distortion
Adjusted
Exercise
Price
Option
Value
Per Share
Contract
Value
Original
Exercise
Price
Adjusted
Exercise
Price
Option
Value
Per Share
Contract
Value
Option
Value
Per Share
Contract
Value
Contract
Revision
Revision
Plus Stock
Price Move
30
35
40
45
50
55
60
65
10.75
12.55
14.34
16.13
17.92
19.72
21.51
23.30
0.000
0.000
0.000
0.003
0.165
1.120
2.789
4.581
0.00
0.00
0.00
0.87
46.16
312.55
778.00
1,278.00
30
35
40
45
50
55
60
65
7.79
9.09
10.39
11.69
12.99
14.29
15.59
16.89
0.000
0.000
0.006
0.256
1.241
2.531
3.830
5.129
0.00
0.00
2.24
98.58
477.71
974.00
1,474.00
1,974.00
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.023
0.00
0.00
0.00
0.00
0.00
0.00
0.19
9.00
0.00
0.00
0.00
0.87
46.16
312.55
777.81
1,269.00
0.00
0.00
2.24
98.58
477.71
974.00
1,473.81
1,965.00
Original
Exercise
Price
251
252
day. With the stock price being at an articially low level, the R-factor for option
adjustment is lower
Ractual
46:561:3033:00 0:50
0:2598:
46:561:30
All open option exercise prices are adjusted from their existing levels by a factor of
0.2598. The call and puts options with an original exercise price of the h30, for example,
have their exercise price rewritten as h30 0.2598 7.79. At the same time, the number of
shares of each option contract increases by a factor of 1/R 3.8486. The two panels (A and
B) below the top panel are ex-dividend day call and put option values. Consider the 30-call.
The rst column is the original exercise price. The Adjusted Exercise Price column is the
exercise price after the contract adjustment. With an R-factor of 0.2598, the adjusted
exercise price is h7.79. The ex-dividend stock price is 11.76, the risk-free rate is 3.89%, and
the risky asset volatility rate is 32.75%. The ex-dividend level of a is 0.9830, as noted
above, and there are no dividends paid during the options remaining life. The value per
share is h3.977, and, since the option now has a denomination of 384.86 shares, the
contract value is h1,530.47.
Economic consequences are summarized in Table 7 under the panel headed With
distortion and reversal. Under this scenario, the stock price is assumed to be driven from
its true level of h53.52 just before the close of trading on the last cum-dividend day to an
articial level of h46.56, and then the stock returns to its true level of h53.52 by the close of
trading on the following day. Since the stock price reverses to its true level, the original 30call (now the 7.79-call) has a value per share of h10.937 at the close on ex-dividend day.
With each option having a denomination of 384.86 shares, the value of one 7.79-call option
contract is h4,209.12. The economic consequences are therefore as follows. First, since the
R-factor was set at an articially low level, the call option holder now has more shares than
he should have. Since the cost of exercising the call remains the same after the contract
adjustment (i.e., 30 100 shares is the same as 7.79 384.86 shares), the long call option
holder has a position value that has increased in value as a result of being awarded more
shares. The value of the additional shares is (384.86278.95) 18.72 or h1,982.65. The
column headed Revision Plus Stock Price Move includes not only the h1,982.65 contract
revision effect but also an additional premium of h696.00 from acquiring the option
position at a deated price (i.e., h1,530.47 vs. h2,226.47).
In summary, if the stock price deviates from its true level on the last cum-dividend day
and then returns to its true level afterward, windfall gains/losses arise from the
proportional contract adjustment. The gains/losses arise from two sources: incorrect
contract adjustment (e.g., h1982.65 in the case of the 30-call) and stock price movement
(e.g., h696.00 in the case of the 30-call). If the distorted stock price is below the true price,
long call option holders benet and short call option holders lose, with the benet/loss
being greatest for in-the-money calls.17 Note that the gains from distortion for the put
options in Table 7 are negative. In other words, long (short) put option holders lose (gain)
if the stock price is below its equilibrium level on the last cum-dividend day. Naturally, if
the stock price is above its equilibrium level, the reverse is true. Whatever the direction,
17
Anecdotally, the Altana call option with the highest trading volume and open interest on May 3, 2007 had an
exercise price of 28.
253
however, the proportional contract adjustment provides a potential prot opportunity if it

is possible to move the stock price from its equilibrium level.
6. Conclusion
We analyze the economic consequences of two commonly applied procedures for
adjusting the terms of a stock option contract when the underlying stock pays an
unexpected special dividend. The rst is the absolute adjustment used in the U.S. and
Canada. On the ex-dividend day, the exercise price is reduced by the amount of the special
dividend. The second is the proportional adjustment used in Australia and Europe. On the
ex-dividend day, the exercise price is reduced and the number of options is increased by a
ratio that reects the amount of the dividend relative to the cum-dividend stock price. In
assessing the fairest procedure, we explicitly model the effect that cash dividends have on
the underlying stocks volatility rate. We explain how standard option valuation models
fail to account for the changes in volatility and show how Rubinsteins (1983) displaced
diffusion model can. Based upon the displaced diffusion option valuation methodology,
we assess the economic effects of the different adjustment procedures and show that the
absolute adjustment is fairest from the option holders standpoint. We also show that the
proportional adjustment can be manipulated if the stock price can be moved from its
equilibrium level.
Appendix A. Sample of special dividends paid by U.S. rms from 2003 to 2009
Firm characteristics are drawn from the CRSP daily data le, nancial statements, and
public press articles (see Table A1).
Table A1
(1) Iomega (IOM)
Special dividend amount per share:
$5.00
Total dividend payment:
$257 million
Source of funds:
Cash
Declaration date:
7/17/2003
Ex-dividend date:
10/2/2003
Share price on announcement date:
$11.40
Dividend as a percent of stock price:
43.9%
Cash and ST investments balance in quarter before dividend $452 million
announcement:
Cash and ST investments balance in quarter after dividend $169 million
payment:
Announcement details:
7/17/2003
In announcing the special dividend, Iomega Chairman David J. Dunn said the
Board of Directors had been y exploring ways to improve shareholders return
on the Companys excess cash. He said Iomega had considered using the cash
for acquisitions but was unable to nd anything that met its y twin goals of
attractive returns and safety for shareholders.
254
Table A1 (continued )
(2) Microsoft (MSFT)
$3.00
$32 billion
Source of funds:
Cash
Declaration date:
11/9/2004
Ex-dividend date:
11/15/2004
$29.77
10.1%
Cash and ST investments balance in quarter before dividend $64.4 billion
announcement:
Cash and ST investments balance in quarter after dividend $34.5 billion
payment:
7/3/2003
The Financial Times reports that Microsoft is considering a special divided of
more than $10 billion to reduce its cash balance. Other options include a share
buyback, acquisitions and higher ordinary dividends, or a mixture of these.
7/18/2003
Microsoft CFO John Connors responds suggestions from analysts and investors
that it use its cash to pay a dividend, saying that the cash is required to pay for
potential antitrust litigation from the European Union and Sun Microsystems
Inc.
3/24/2004
European antitrust decision is made and analysts expect that the resolution of
Microsofts legal issues should free the company to distribute some of its cash
reserves to shareholders.
7/20/2004
Microsoft announces plan to pay a $3 per share special dividend subject to
shareholder approval.
(3) Commonwealth Telephone Enterprises (CTCO)
$13.00
$295 million
Source of funds:
Cash
Declaration date:
5/3/2005
Ex-dividend date:
6/13/2005
$50.65
25.7%
announcement:
payment:
6/25/2003
The Wall Street Journal reports that CTCO is looking for acquisitions, but if
they cannot nd a viable opportunity in 1218 months they will consider using
their accumulated cash for share repurchases or a dividend payment.
5/3/2005
CTCO announces $13 per share special dividend. In describing the dividend,
President and CEO of CTO Mike Mahoney said that it is y the best use of a
substantial portion of our cash at this time for our shareholders.
(4) Saks Inc. (SKS)
Source of funds:
Declaration date:
Ex-dividend date:
$4.00
$550 million
Sale proceeds
3/6/2006
5/2/2006
$18.61
255
21.5%
Cash and ST investments balance in quarter before dividend $1,152 million
announcement:
payment:
10/31/2005
SKS announces that it has agreed to sell its Northern Department Store Group
(NDSG) for $1.1 billion in cash plus the assumption of liabilities. Steve Sadove,
the CEO of SKS, indicates that it intends to distribute a substantial portion of
the sale proceeds to shareholders through share repurchases, a special dividend,
or a combination of both. The deal is expected to be completed in the rst
quarter of 2006
3/1/2005
SKS announces that it intended to declare a special dividend of $4 per share
immediately following the closing of the sale of the NDSG, expected on March
13, 2005.
3/6/2005
The sale of NDSG is completed, and SSKS announces that its Board of
Directors has authorized the special dividend.
(5) Great Atlantic and Pacic Tea Co. (GAP)
$7.25
$300 million
Source of funds:
Sale proceeds
Declaration date:
4/4/2006
Ex-dividend date:
4/12/2006
$35.13
20.6%
announcement:
payment:
7/19/2005
GAP announces that it has sole A&P Canada to Metro Inc. for $1.2 billion in
cash and $500 million in shares.
4/4/2006
GAP announces a $7.25 special dividend. Executive Chairman of the Board of
Directors Christian Haub says that the move reects y the substantial
resources we have on our balance sheet as a result of last years sale of A&P
Canada.
(6) Saks Inc. (SKS)
$4.00
$550 million
Source of funds:
Cash and sale proceeds
Declaration date:
10/3/2006
Ex-dividend date:
12/1/2006
$17.57
22.8%
announcement:
payment:
8/2/2006
SKS announces that it has agreed to sell its Parisian department store to Belk for
$285 million in cash. The company reiterates that it intends to distribute part of
its existing cash balance and the net proceeds from the Parisian sale to
shareholders.
256
10/2/2006
10/3/2006
Sale of Parisian is completed.

SKS declares special dividend of $4 per share.
(7) National Information Consortium (EGOV)

$0.75
$47 million
Source of funds:
Cash
Declaration date:
1/31/2007
Ex-dividend date:
2/8/2007
$5.27
14.23%
announcement:
payment:
1/31/2007
In announcing the special dividend Jeff Fraser, Chief Executive Ofcer of
National Information Consortium (NIC), said that y the strength of our
balance sheet and condence in the future prospects of NIC prompted the Board
of Directors to declare this special cash dividend.
(8) Heartland Express (HTLD)
$2.00
$197 million
Source of funds:
Cash
Declaration date:
5/14/2007
Ex-dividend date:
5/22/2007
$16.86
11.9%
announcement:
payment:
5/14/2007
Heartland Express Inc. declares a special dividend of $2 per share. No additional
details were announced.
(9) Steelcase Inc (SCS)
$1.75
$248 million
Source of funds:
Cash
Declaration date:
12/19/2007
Ex-dividend date:
12/28/2007
$15.15
11.6%
announcement:
payment:
12/19/2007
Steelcase announces the special dividend. In making the announcement, the CFO
David C. Sylvester said the rms y targeted cash balance has been reduced,
allowing for the declaration of the special dividend today.
257
(10) Innovative Solutions and Support Inc (ISSC)
$1.00
$17 million
Source of funds:
Cash proceeds of lawsuit
Declaration date:
9/8/2008
Ex-dividend date:
9/16/2008
$6.15
16.26%
Cash and ST investments balance in quarter prior to
$41 million
dividend payment:
payment:
11/7/2007
ISSC receives favorable verdict in its trade secret misappropriation case against
Kollsman, J2 Inc. and other defendants. The court awards damages of more than
$6 million and will hear claims for punitive damages.
7/7/2008
Court awards additional damages, bringing the total to $23 million.
9/3/2008
ISSC reaches settlement with Kollsman Inc. for an agreed payout of $17 million.
9/8/2008
ISSC announces a special dividend of $1 per share said that the special dividend
will be funded in cash from the $17 million proceeds received in connection with
a settlement with Kollsman, Inc.
References
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637659.
Campbell, J.A., Beranek, W., 1955. Stock price behavior on ex-dividend dates. Journal of Finance 10, 425429.
Cox, J.C., Ross, S.A., Rubinstein, M., 1979. Option pricing: a simplied approach. Journal of Financial
Economics 7, 229264.
Durand, D., May, A.M., 1960. The ex-dividend day behavior of American Telephone and Telegraph stock.
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Elton, E.J., Gruber, M.J., 1970. Marginal stockholder tax rates and the clientele effect. Review of Economics and
Statistics 52, 6874.
Fleming, J, Whaley, R.E., 1994. The value of wildcard options. Journal of Finance 49, 215236.
Graham, J.R., Michaely, R., Roberts, M.R., 2003. Do price discreteness and transactions costs affect stock
returns: comparing ex-dividend pricing before and after decimalization. Journal of Finance 58, 26112635.
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Journal of Financial Markets 15 (2012) 233257

Stock option contract adjustments: The case of

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Commonwealth Telephone Enterprise: CTCO announced a $13 a share special dividend

Whaley (1981) corrects a misspecication in the original Roll (1977) formula.

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

where X is the exercise price of the option,

lnaS=XerT S1a 0:5s2A T

3.2. Valuing American-style options

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Put Option Value

4. Determining fairest special dividend contract adjustment

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Windfall Value Change

Panel B. Put Option Values

Windfall Value Change

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Put Option Exercise Prices

Panel B. Absolute Contract Adjustment

Put Option Exercise Prices

Panel C. Proportional Contract Adjustment

Put Option Exercise Prices

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Put Option Exercise Prices

Panel B. Absolute Contract Adjustment

Put Option Exercise Prices

Panel C. Proportional Contract Adjustment

Put Option Exercise Prices

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Put Option Exercise Prices

Panel B. Absolute Contract Adjustment

Put Option Exercise Prices

Panel C. Proportional Contract Adjustment

Put Option Exercise Prices

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Scumdividend Dregular Dspecial Dbonus

See Pharma Marketletter, August 1, 2006.

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

No. of days from last cum-dividend day

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

Panel A. Market Parameters

With distortion: Stock price 6.96

With distortion and reversal:

Panel B. Call Option Values

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Panel C. Put Option Values

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257

however, the proportional contract adjustment provides a potential prot opportunity if it

K. Barraclough et al. / Journal of Financial Markets 15 (2012) 233257