Debate continues whether dividends can be interpreted as their own asset class, separate from stocks and other equity-related products. The discussion has achieved a new perspective recently thanks to the introduction of new instruments, such as dividend futures and options. These products have been introduced on many European-listed equities and are coming to the United States. Their function is simple; they enable investors to trade dividends independently of the underlying stock.
Dividend estimates are, therefore, not only of interest to equity investors who want to earn a steady income, but they also play a significant role in derivatives pricing for equity forwards, futures and options as well as dividend futures and options. As changes in the price of the underlying usually dominate the price of an equity option or futures contract, the effects of changes in implied dividends often are overshadowed or ignored.
If investors want to avoid equity risk and implement a strategy based on their view of future dividend payments, they can choose between different approaches:
- Investing in a long spot (including financing) and short equity forward combination, which practically equates to a dividend swap.
- Using long/short combinations of different equity forwards/futures, which would lead to dividend exposure between the two expirations.
- Buying and selling equity options based on put/call parity (see "Between puts and calls," ).
- Using new instruments such as dividend options or futures.
Prices and dividends
Using different maturities for equity forwards/futures (or, equivalently, equity option pairs) on an index leads to a term structure for implied dividends. The graph "Implied value" (below) illustrates the present value of dividends that are implied by prices of listed equity options on the S&P 500 using put-call parity.
The same procedure can be used for the EuroStoxx 50, as well, to compare implied dividend levels vs. the S&P 500 for different maturities. It turns out that expected dividend payments implied on listed EuroStoxx 50 equity options are quite low and even falling for longer dated maturities, indicating negative dividend growth for the years to come (see "Slippery slope").
There is no economic or financial argument that would support these falling dividend levels over a longer time horizon. Some people interpret this phenomenon as a structural inefficiency in the derivatives market. According to some analysts, this unusual shape of the dividend curve is explained by an overhang of bullish structured equity products in the European markets.
Whatever the reason, the gap between higher implied dividend increases for the S&P 500 vs. flat or even falling changes of dividend payments for the EuroStoxx 50 seems to offer profit potential to investors. Dividend payments, however, are highly correlated with stock market movements as displayed in "Index vs. dividends" (see below), which plots the S&P 500 spot vs. 12-month realized dividend levels, making a pure dividend long- or short-play risky.
Position for profit
Profit and losses would be affected strongly by movements in the price of equities. The solution would be a long EuroStoxx 50/short S&P 500 dividend strategy to offset general stock price movements. Although the correlation for the EuroStoxx 50/S&P 500 dividend yield pair is slightly lower than the correlation between the dividend yield of FTSE or Nikkei 225 to the EuroStoxx 50, the correlation figure, especially for longer-dated dividends, still is above 60%, offering the support necessary to take this trade.
Implementing the strategy via derivatives, for example, could include options with December 2012 and December 2013 expiries:
|
Direction |
Underlying |
Call/Put |
Maturity |
Strike |
|
Long |
Eurostoxx50 |
Call |
Dec 2012 |
At the money |
|
Short |
Eurostoxx50 |
Put |
Dec 2012 |
At the money |
|
Short |
Eurostoxx50 |
Call |
Dec 2013 |
At the money |
|
Long |
Eurostoxx50 |
Put |
Dec 2013 |
At the money |
|
Short |
S&P500 |
Call |
Dec 2012 |
At the money |
|
Long |
S&P500 |
Put |
Dec 2012 |
At the money |
|
Short |
S&P500 |
Put |
Dec 2013 |
At the money |
|
Long |
S&P500 |
Call |
Dec 2013 |
At the money |
This investment would create a long synthetic position for the EuroStoxx 50 until 2012 and a short synthetic position until 2013 and vice versa for the S&P 500. Put/call parity explains why the trade should be set up this way (again, see "Between puts and calls" on ). Here’s the calculation:
Present value of all dividends until maturity = Put Price – Call Price + Spot – PV(strike)
Therefore:
PV(dividends in 2013) = PV(dividends until 2013) – PV(dividends until 2012) = Put Price2013 – Call Price2013 + Spot – PV2013(strike) – (Put Price2012 – Call Price2012 + Spot – PV2012(strike))
The spot price cancels out. So assuming that interest rate risk is hedged, we get the desired exposure to the (present value of) dividend payments between 2012 and 2013.
Trade risk
This strategy isn’t without its downside, of course. Investors should be aware of the pitfalls.
The biggest factor distorting the payout of the strategy is the influence of interest rates if the position remains unhedged against those movements. Changing the three-year interest rate from 2% to 2.1% (assuming unchanged interest rates otherwise and a strike price of 3000 for EuroStoxx 50 options) would change the present value of 2013 dividends by more than eight index points. Hedging against interest rate movements, therefore, is crucial.
Next, bid/ask spreads have to be considered when setting up the trade. In addition, some practitioners argue that put-call parity does not exactly hold true in practice for different reasons, such as the use of the right interest rate for discounting, tax issues, etc.
If investors want to speculate on movements of implied dividends on the EuroStoxx 50 alone, they also could trade dividend futures. These instruments have been introduced recently in Europe and give an investor the opportunity to participate in increases in dividend expectations directly. No such futures exist on U.S. indexes such as the S&P 500 yet, but some investors expect that to happen soon. Instead, dividend options on the EuroStoxx 50 or the S&P 500 can be traded on exchanges already.
Dividends in general are becoming tradable more easily without the exposure to the equity itself. Whether investors choose to use instruments such as equity forwards/futures and options or new instruments, such as dividend futures and options, has to be decided on a case-by-case basis. Although the instruments can be used for trades on single-stock dividends, it can be a Herculean task to determine the payout predictions for a specific company, because of the complexity of the analysis. The difference in implied dividends between the S&P 500 and the EuroStoxx 50, on the other hand, seems to be a structural inefficiency that investors should keep an eye on, whether exploited via options or other instruments.
Between puts and calls
Assume a stock trades at S = $40, the difference P – C of a put to a call option with the same maturity and strike price is $3. Let the present value of the strike price be $41. Put-call parity would imply a present value for the dividend of:
PV(dividends) = P – C + S – PV(strike) = $3 + $40 – 41$ = $2
If an investor expects the company to pay $3 — in present value terms — instead of the $2 implied, he should borrow money, invest it in the stock and create a short synthetic futures by selling a call and buying a put on the underlying.
By owning the stock, the investor would profit from the higher dividend payment while being hedged by the options.
Marco Erling works as portfolio manager and quantitative analyst for structured products with HSBC Global Asset Management. He studied mathematics at the University of Dortmund in Germany and graduated with an MBA from ESADE Business School in Barcelona. He is a CFA Charterholder and a Certified FRM holder. E-mail him at Marco.Erling@HSBCTrinkaus.de.
