Question

Mr. Smith is holding an ABC call option expiring in 6 months with an exercise price of $125. ABC stock is selling for $150 today and ABC Corporation announced a dividend payment of $1, which will be paid in 2 months. Current interest rate is zero percent. Mr. Smith weighs exercising the option now. Do you recommend him to exercise the option?

Explain why or why not.

Answer 1

The option is in-the-money by $25 and the company has announced a dividend.

Yes, Mr. Smith should exercise the call option. There are majorly 2 reasons for this, first, is after the payment of dividend, the stock price usually falls and the dividend yield is negatively correlated with the stock price, especially immediately after the payment of dividend. Secondly, due to the prevalence of zero interest rates, under normal circumstances, we cannot expect the stock prices to move abnormally high since the risk-free rate is extremely low.

Even if we analyze using the Black-Scholes model and binomial option pricing models, both higher dividend yield, as well as the low risk-free rate of interest, is associated with lower stock price upward movement. Hence, Mr. Smith should consider exercising the option now as to pocket the positive payoff of the in-the-money call option.