Friday, June 18, 2010

Did The Market Expect A BP Oil Spill Over A Year Ago?

About 12 to 18 months ago, a friend of mine bought some BP stock because he was in search of income and it had a high dividend yield. The dividend yield at the time was in the 8 to 10 percent range and because it was high I used the put call parity relationship to see if the market was expecting a dividend cut.

When prices of stocks and their associated put and call options are available, the prices can be used to compute the market's expectation of future dividends using the put-call parity relationship.

Put Call Parity states that the price of a stock less it expected dividends (discounted to current dollars) until the maturity of the stock options plus the price of a put option on the stock is equal to the price of a call option on the stock plus the value of a bond equal to the the discounted valued of the exercise price of the stock options.

When I computed the expected BP dividend 12-18 months ago using the then current BP prices at the time of its stock, its call option and its put option, the dividend adjustment expected by the market as represented in the put call parity relationship was about half of the then current dividend.

BP at the time had more than enough earnings and cashflow to pay its dividends. The stock and option markets were expecting some extraordinary event at least as far back as 12-18 months ago that would cause BP to reduce its dividend.

Was the market expecting an oil spill disaster by BP?

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