An equity return series can show a false loss if a split or dividend is handled incorrectly. Equity derivatives also depend on the shares, dividends and index methodology specified by the contract. This lesson explains those claims and corporate actions, then connects index construction to cost-of-carry pricing.
The no-arbitrage index futures relation is the simplest cost-of-carry formula in the programme. Use the actual index level and the dividend income on its replicated basket. Historical adjusted-close data serve return estimation; they are not automatically the spot input for a live forward.
Learning objectives. By the end of this note you should be able to:
- distinguish common and preferred shares and state priority in cash flows and liquidation;
- walk through declaration, ex-date, record and payment for a cash dividend, and explain the ex-date price drop;
- classify and adjust for stock dividends, splits, reverse splits, rights issues and spin-offs;
- explain how price-weighted and cap-weighted indices adjust divisors or weights after corporate actions;
- state the equity risk premium and why it is largely irrelevant to no-arbitrage derivative prices;
- derive for an index futures and describe index arbitrage.
In this lesson
- Common and preferred shares
- Cash dividends and payout yield
- Corporate actions: taxonomy and price adjustments
- Stock indices and divisor mechanics
- Equity risk premium
- Index futures pricing and arbitrage
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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