From the May 01, 2011 issue of Futures Magazine • Subscribe!

Dividend options and futures

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.

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