Stock Option Contract Adjustments: The Case of Special Dividends

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.

Keywords: stock option, special dividend, contract adjustment, displaced diffusion process, nested binomial lattices

JEL Classification: G11, G13, G14, G15