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Do dividend initiations signal a reduction in risk? Evidence from the option market

Review of Quantitative Finance and Accounting volume 42, pages 143–158 (2014)Cite this article

Abstract

We investigate whether dividends convey information about the risk of a company by examining the reaction of implied volatility in the option market to the announcement of a dividend initiation. Implied volatility decreases after the announcement and the magnitude of the decline in volatility is positively related to both the magnitude of cumulative abnormal returns (CAR) in the equity markets and the size of the dividend. Additionally, firms with weaker (stronger) corporate governance experience larger (smaller) declines in implied volatility. Cross sectional analysis shows that a one-standard deviation decline in measures of risk increases the 2-day CAR by 74–137 basis points. Our results suggest that dividend initiations signal declining firm risk.

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Fig. 1

Notes

  1. See Black (1976) for detailed descriptions of the puzzle.

  2. A partial list of studies that examine the first order effect of dividend changes include Aharony and Swary (1980), Asquith and Mullins (1986), Bernartzi et al. (1997), Cheng et al. (2007), Fehrs et al. (1988), Ghosh and Woolridge (1988), Healy and Palepu (1988), Lacina and Zhang (2008), Michaely et al. (1995), Nissim and Ziv (2001), and Van Eaton (1999).

  3. Docking and Koch (2005) focus on market volatility instead of the risk of a firm. Specifically, they find the announcement of a dividend decrease elicits a significant decrease in stock price when market returns have been up and volatile, while the announcement of a dividend increase causes a significant increase in stock price when market returns have been down and volatile.

  4. Acker (1999) examines changes in implied standard deviations surrounding dividend announcements in the United Kingdom, but the dividend paying process in the UK. is substantially different from that in the US. Jayaraman and Shastri (1993) examine volatility changes around the announcement of special dividends compared to ordinary dividends, but the sample is quite small and methodological flaws exist since they average estimates of volatility over time. These studies are not particularly relevant or comparable to this study.

  5. Special dividends (third digit of CRSP distribution code is “7”) are generally nonrecurring and are excluded from this study, as prior research (e.g. Brickley 1983) has demonstrated less information content associated with special dividends.

  6. This data was purchased from Delta Neutral in early 2006. We elected not to extend the sample period by purchasing additional data for more recent years due to the onset of the financial crisis in 2007.

  7. Currently no closed-form solution exists to explicitly solve for implied volatility using the Black–Scholes model, so iterative processes are used.

  8. As used here, "matching" means the put option must have the same strike price and term to expiration as the call option.

  9. We also used the CRSP equal-weighted index in the analyses and the use of equal-weighted index produces results similar to those using value-weighted index.

  10. We also considered adding GIM INDEX as a control variable. The coefficient for GIM INDEX was negative, suggesting that weaker governance reduces the CAR. However, this variable was not statistically significant in any of the regressions, so we did not include it in the presented results.

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Acknowledgments

We thank Wayne Lee, Rodrigo Hernandez, Craig Rennie, Abhay Kaushik, Alice Adams Bonaime, and seminar participants at University of Arkansas, 2010 SFA Conference, and 2011 FMA Conference for valuable comments. We acknowledge the Harold A. Dulan Professorship Foundation and Robert E. Kennedy Professorship Foundation at the Sam M. Walton College of Business for financial support. A portion of this work was completed while Jones was at Drury University, from which he acknowledges summer research support. Jones and Gu also acknowledge database support from the Sam M. Walton College of Business.

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Authors and Affiliations

  1. College of Business, Missouri State University, Springfield, MO, 65897, USA

    Jeffrey S. Jones

  2. College of Business, University of Dallas, Irving, TX, 75062, USA

    Jenny Gu

  3. Harold A. Dulan Chair Professor in Capital Formation, Robert E. Kennedy Chair Professor in Investment, Sam M. Walton College of Business, University of Arkansas, Fayetteville, AR, 72701, USA

    Pu Liu

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  1. Jeffrey S. Jones
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  2. Jenny Gu
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  3. Pu Liu
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Correspondence to Pu Liu.

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Jones, J.S., Gu, J. & Liu, P. Do dividend initiations signal a reduction in risk? Evidence from the option market. Rev Quant Finan Acc 42, 143–158 (2014). https://doi.org/10.1007/s11156-012-0337-5

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  • DOI: https://doi.org/10.1007/s11156-012-0337-5

Keywords

  • Dividends
  • Risk
  • Implied volatility
  • Initiations

JEL Classifications

  • G10
  • G14
  • G35