Let us discuss today about the dividend yield and its impact on forward prices of commodities:

·         The dividend yield is expressed in percentage terms. It is ratio or a fraction expressed as the dividend received per share / current trading price of the share.

 

For example,

·         Assume that a company has issued shares for face value of $1.00

·         The stock / share is presently trading in the market for $5.50

·         For the financial year 2012-2013 (April – March), the company declared a dividend of 50% of face value.

·         In that case, the 50% of face value $1 = $0.50, is the dividend declared by the company per share.

·         This implies any investor who is holding one share of the company will be receiving $0.50 as a dividend from the company.

·         The dividend yield in this case is $0.50/$5.50 = 0.0909 or 9.09% (dividend yield in % terms)

·         Now, understand the impact of dividend yield on commodities or stocks:

·         Dividends are nothing but distribution of company profits.

·         Had the company not declared dividends, the dividends would have been in the form of retained earnings in the company books.

·         This indicates by declaring dividends, the company indirectly giving a hint, that it is not interested to keep profits as retained earnings.

·         Let us come back to our discussion.

·         By distribution of profits to shareholders, in the form of dividends, the book value of the shares in the company records would come down.

·         Therefore, after declaring the dividends, as the owner of shares will receive the dividends, but the book value of the shares will come down.

·         As the book value of a share comes down after distribution of dividends, the market price of share is also expected to come down.

·         This means the dividend yield is expected to reduce the future value of the commodity.

·         Look at the following example to understand the impact of dividend yield in commodity markets:

·         Consider T₀ = Current Time

·         T₂ = Future time.

_·          An investor wants to buy a commodity at T₀ from a forward seller at time T₂

·         Assume that the present price of the commodity is $20.00

·         The forward seller would include the following costs in the forward price at time T₀.

·         $1.00 storage costs for the time T₀ – T₂

·         $1.50 as the insurance cost for the time T₀ – T₂

·         $1.50 as the inflation cost for the time T₀ – T₂

·         The total of all the above comes to: $4.00 for the time T₀ – T₂

·         At the same time, the commodity is expected to pay $0.50 as the dividend to the owner of the commodity between the time T₀ – T₂.

·         Therefore the total amount to be included in the forward price is:

·         $4.00  (expenses) - $0.50 (dividend income on commodity) = $3.50 as the net cost for the forward seller for holding the commodity for the time T₀ – T₂

·         Therefore the seller will keep the forward price to sell at $23.50

·         In this example, the time value of money is not considered.

·         Therefore please understand that is why the dividend yield is reduced from the formula used for calculating the forward price of the commodity.

·         Therefore expected future price of the stock = S₀e^{(r – δ)}.