DIVIDEND POLICY AND STOCK PRICE VOLATILITY

Dividend Policy and Stock Price Volatility

Dividend Policy and Stock Price Volatility

Introduction

Dividend policy remains a source of controversy despite years of theoretical and empirical research, including one aspect of dividend policy: the linkage between dividend policy and stock price risk (Allen and Rachim, 1996). Paying large dividends reduces risk and thus influence stock price (Gordon, 1963) and is a proxy for the future earnings (Baskin, 1989). A number of theoretical mechanisms have been suggested that cause dividend yield and payout ratios to vary inversely with common stock volatility. These are duration effect, rate of return effect, arbitrage pricing effect and information effect. Duration effect implies that high dividend yield provides more near term cash flow. If dividend policy is stable high dividend stocks will have a shorter duration. Gordon Growth Model can be used to predict that high-dividend will be less sensitive to fluctuations in discount rates and thus ought to display lower price volatility.

Agency cost argument, as developed by Jensen and Meckling (1976) proposed that dividend payments reduce costs and increase cash flow, that is payment of dividends motivates managers to disgorge cash rather than investing at below the cost of capital or wasting it on organizational inefficiencies (Rozeff, 1982 and Easterbrook 1984). Some authors have stressed the importance of information content of dividend (Asquith and Mullin, 1983; Born, Moser and officer 1983). Miller and Rock (1985) suggested that dividend announcements provide the missing pieces of

information about the firm and allows the market to estimate the firm's current earnings. Investors may have greater confidence that reported earnings reflect economic profits when announcements are accompanied by ample dividends. If investors are more certain in their opinions, they may react less to questionable sources of information and their expectation of value may be insulated from irrational influence.

Rate of return effect, as discussed by Gordon (1963), is that a firm with low payout and low dividend yield may tend to be valued more in terms of future investment opportunities (Donaldson, 1961). Consequently, its stock price may be more sensitive to changing estimates of rates of return over distant time periods. Thus expanding firms although may have lower payout ratio and dividend yield, exhibit price stability. This may be because dividend yields and payout ratio serves as proxies for the amount of projected growth opportunities. If forecasts of profits from growth opportunities are less reliable than forecasts of returns on assets in place, firms with low payout and low dividend yield may have greater price volatility. According to duration effect and arbitrage effect, the dividend yield and not the payout ratio is the relevant measure. The rate of return effect implies that both dividend yield and payout ratio matters. Dividend policy may serve as a proxy for growth and investment opportunities. Both the duration effect and the rate of return effect assume differentials in the timing of the underlying cash flow of the business. If the relationship between risk and dividend policy remains after controlling for ...