Dividend Initiations, Information Content, Informed Trading In The Options Market And Stock Liquidity

Balasingham Balachandran

La Trobe University -Department of Economics and Finance; Financial Research Network (FIRN)

Huu Nhan Duong

Monash University – Department of Accounting and Finance; Financial Research Network (FIRN)

Michael Theobald

University of Birmingham – Department of Accounting and Finance

Yun (Tracy) Zhou

Dept. of Economics and Finance, La Trobe University

October 8, 2015

Abstract:

Announcement period abnormal returns to dividend initiation are negatively related to abnormal options trading. This relation is more prevalent among firms with abnormal call options trading and liquid options. Long-term returns following dividend initiations are only evident in firms without options. We find positive abnormal earnings and improvements in stock liquidity following dividend initiation. Abnormal earnings and improvements in liquidity are stronger for firms without options. Overall, dividend initiations of firms without options have strong information content regarding future prospects and liquidity while stocks with options tend to be more efficiently priced and experience lower adjustments in liquidity and returns.

Dividend Initiations, Information Content, Informed Trading In The Options Market And Stock Liquidity

Brav et al. (2005) survey and interview a large number of U.S. company executives and document that 80% of executives believe that the dividend decision does convey information to investors. Moreover, their survey indicates that managers are extremely conservative with respect to their firm’s dividend policy, largely because they believe that a dividend policy is significantly more inflexible than a repurchase policy. Kale, Kini, and Payne (2012) argue that this perceived inflexibility makes managers particularly averse to initiating dividends, such that dividend initiation (hereafter DI) is an important stage in the firm’s life cycle. They show that higher-quality firms in their sample initiate dividends to attract investor clienteles such as institutional investors who will monitor them and validate their superior future prospects. However, very little is known regarding whether informed traders exploit their information about forthcoming DI announcements by trading options. Accordingly, we extend the prior research by examining informed traders’ behavior in the option market immediately prior to the announcement of DI and the impact of this informed trading on the announcement period price reaction.

Brav et al. (2005) document that CFOs of non-dividend paying firms agree that dividends are inflexible, and that this makes them very hesitant to begin paying dividends in the first place. They further document that nearly 58 percent of CFOs of non-dividend payers agree that a sustainable increase in earnings might lead to dividend initiation. Officer (2011) finds that firms with low Tobin’s Q and high cash flow have significantly more positive announcement period abnormal returns than do other firms and concludes that this finding is consistent with the hypothesis that reductions in the agency costs of overinvestment at firms with poor investment opportunities and ample cash flow are reflected in higher abnormal returns. In this paper, we also investigate the information content in DI, and their association with the reduction in agency costs of free cash flow and future sustainable earnings. We also examine how the information content of DI announcements differs as between firms with and without listed options, and how preannouncement options trading affects announcement period abnormal returns for firms with options.

Prior studies examine long term returns subsequent to dividend initiation with mixed results. Michaely, Thaler, and Womack (1995) find an upward price movement prior to DI announcements that then persists for a three-year period subsequent to the DI announcements. Boehme and Sorescu (2002) show that stocks that initiate dividends experience a significantly positive price drift only when the Fama–French calendar time portfolios are equally weighted, whereas the price drift becomes generally insignificant when the portfolios are value weighted. However, very little is known regarding post announcement price drift for firms with and without listed options following DI announcements. Brav et al. (2005) document that 58 percent of executives of non-dividend payers agree that institutional shareholders have an important influence on dividend initiation. Allen, Bernardo, and Welch (2000) assert that institutional investors have superior ability in assessing firm quality and, therefore, higher quality firms are prepared to bear the tax-based costs of dividends to attract these better-informed investors. Banerjee, Gatchev, and Spindt (2007) show that less (more) liquid firms that have never paid dividends are more (less) likely to initiate dividend payments. Brockman, Howe, and Mortal (2008) examine the impact of stock market liquidity on managerial payout decisions and show that dividend-initiating firms are less liquid than non–dividend-initiating firms. We extend the prior research to examine post announcement price drift, earnings performance, dividend payments and improvement in liquidity following DI for firms with and without listed options separately to understand whether they differ between these two groups and whether these two groups follow different dividend policies.

Dividend Initiations

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