How REC F&O contracts will be adjusted for special dividends

In its meeting held on 27th October 2022, the board of directors of REC Ltd has approved an Interim Dividend pay-out of Rs 5/- per equity share of face value of Rs. 10/- each. For the purpose of interim dividend eligibility, the record date has been fixed as November 09th, 2022. That means an investor seeking to get the interim dividend will have to possess the shares in his / her demat account by the close of 09th November 2022. Obviously, if the shares have to be in the demat account by 09th November, the shares have to be purchased latest by T-2 date to be eligible for delivery.

Now, since 09th November is a Wednesday, the T-2 trade date will be Friday 04th November 2022 since apart from the weekend, even 08th November is a trading holiday. That means, the investor intending to get this interim dividend of Rs5 per share has to purchase the shares latest by 04th November so that the shares are in the demat account by 09th November. That means, 04th November will be the last cum-dividend date and on the next trading day i.e. 07th November, Monday, the stock of REC Ltd will go ex-dividend. Normally, the price adjustment for any corporate action happens on the ex-date depending on the type and the size of the corporate action.

Corporate action adjustment in F&O contracts?

This is a slightly nuanced question and we need to look at all the facets of this story. But before we get into the dividend part of it, remember that all corporate actions like bonus issues, rights and stock splits require the F&O adjustment to take place. The F&O adjustment takes place in terms of the strike price of the options contract, the market lot or the market multiplier and the size of the position held by the investor. While the adjustment for bonuses and splits are fairly straightforward, the F&O adjustment for dividend payments is slightly more complex. It boils down to whether the dividend so declared is an ordinary dividend or it is an extraordinary dividend. Here is how it is done.

How are dividends adjusted in the case of F&O contracts?

That brings us to the basic question when and how are dividend adjustments made to the F&O contracts. It depends on whether the dividend so declared is an ordinary dividend or an extraordinary dividend. Here is how it is decided. If the dividend declared is below 2% of the market value of the underlying stock, it would be deemed to be ordinary dividends. In such cases, no adjustment in the Strike Price would be made for ordinary dividends. However, in case the dividend is above 2% of the market value, then the adjustment is made to the strike price of the F&O contract. 

There is a slight background to this. Initially, when the extraordinary dividend rule was set by SEBI, it was decided to keep 10% of the market value worth of dividends as the cut-off for extraordinary. However, this created a problem since today most of the large companies pay interim dividends. Hence it may be tough to get a cumulative picture. Hence, the threshold was first reduced from 10% to 5% and then to 2%, which is where it stands now. In the case of REC Ltd, the relevant price was Rs96.50 and the dividend of Rs5 per share works out to 5.18%. Since it exceeds 2%, it is extraordinary dividend.

The other question is what is the cut-off date considered to decide whether the dividend is ordinary or extraordinary? Here, the market price would mean the closing price of the stock on the day previous to the date on which the announcement of the dividend was made by the Company post the meeting of the Board of Directors. However, in case where the announcement of dividend is made after market hours, same day's closing price is taken as the market price. In the case of ordinary dividends i.e. less than 2% of the price, no adjustment is made by the exchange and the dividend gets adjusted in the market price.

Adjustment process for dividends in F&O

In case the dividend is classified as extraordinary dividend based on the criteria above, the total dividend amount would be reduced from all the strike prices of the option contracts on that stock. Therefore, the revised strike prices would be applicable from the ex-dividend date, which is normally the trading date just prior to the record date. Here are key points.

    a) In the case of futures contracts on REC Ltd, the base price of the Futures contracts on November 04th, 2022 will be the reference rate less the aggregate amount of Rs5 per share. The reference rate will be the daily MTM settlement price.

    b) In the case of options contract, the dividend i.e. Rs5/- per share will be deducted from all the cum-dividend strike prices on the ex-dividend date. 

    c) All such adjustment for corporate actions would be carried out on the last day on which a security is traded on cum-basis in the underlying equities market, after the close of trading hours.