Dividend futures – a new sophistication in hedging

Dividend futures – a new sophistication in hedging

The hot new idea of the past two years in listed equity derivatives has been dividend futures and options. Exchanges all over the world have started to offer them, and the main contracts have attracted brisk trading. As Roger Aitken reports, many equity derivative specialists are convinced the product is here to stay.

On June 16, as costs mounted from BP’s Gulf of Mexico oil spill, the company announced it would cancel its first quarter dividend, due to be paid five days later, and its second and third quarter dividends.

The move had been widely expected but was still a blow to UK equity investors. BP’s dividends usually make up a staggering 12% of all dividends paid by FTSE 100 companies. BP’s shares lost 5p on the day to £3.37.

Yet one group of investors was happy – those who had hedged their exposure to UK dividends using a new product.  

Dividend derivatives: the basics

Index dividend futures track the dividends paid by all the companies in the index during one calendar year.

On the ex-dividend date, when the dividend is about to be paid, the monetary value of each dividend is converted into a number of index points and added to the index.

Providers such as Stoxx tend to publish the value of the index daily.

“What one is basically doing when buying such a future is essentially buying the value that will be realised at maturity,” says Eric Jullien De Pommerol, head of the delta one desk at JP Morgan in London. “For example, if a market participant buys a December 2011 contract, they’ll be buying the number of points which are going to be realised between December 2010 and December 2011 maturity.”

The FTSE 100 Dividend Index Futures are worth £10 an index point, while for the Euro Stoxx 50 equivalent, a single point represents €100. At CBOE, it is $100 a point.

Nearly all the activity at Eurex is in 2011 contracts. “There is a lot of certainty in the 2010 contracts and investors are looking forward to 2011, 2012 and beyond,” says Stuart Heath, the exchange’s product manager for dividend derivatives.

Derivatives that convey exposure to dividends only, rather than companies’ share prices, have been traded over the counter in Europe for at least a decade, often under the name of dividend swaps. The instrument can be linked either to the dividends of a single company, or to those of all the companies in an index.

Then, in June 2008, Eurex became the first exchange to list such a contract, with its futures on the dividends of the Euro Stoxx 50.

Since then other exchanges have followed, first in Europe and recently in Asia. Safex, the derivatives branch of the Johannesburg Stock Exchange, has caught the bug too, with dividend futures on three stocks – Marks & Spencer, General Electric and AT&T.

JP Morgan was one of the first banks to begin offering the product OTC. Eric Jullien De Pommerol, head of the bank’s delta one desk in Europe, says the story started with banks offering their clients structured equity products, often capital-guaranteed. The banks were left with considerable dividend risk exposure on their books, and wanted a way to pass it on.

Now, De Pommerol says, “a large majority” of JP Morgan’s dividend futures trades are with listed contracts. “It began initially and mainly with hedge funds, fast money and relatively sophisticated clients trading dividend futures, ” he says. “Then, when futures open interest grew, we began to see some more traditional clients and even some retail types.”

Global interest

JP Morgan’s European delta one desk now trades dividend futures heavily, for clients and the bank itself. Most of its flows are from Europe, some from further afield.

“Market participants who usually invest in European dividends are normally very familiar with European companies,” De Pommerol says. “And, given that we’re a client-facing business, most of the risk in our books is based on client products.

“So, we can have dividend exposure by selling some forwards, for example, even if the dividend may not be the primary reason for the trade. Alternatively, we can deal dividend derivatives directly with clients too.”

John O’Neill, head of product development for equity and OTC derivatives at NYSE Liffe in London, is another enthusiast.

“What we have witnessed over the past couple of years is the launch of a very successful asset class,” he says. “The volumes for our FTSE 100 Dividend Futures, launched in May 2009, have been excellent. We’re pleased with the product.”

By the end of June 1.3m contracts had been traded, with 400,000 lots of open interest. “That level of open interest points to an extremely healthy long term product,” O’Neill contends.  

Eurex’s Euro Stoxx 50 Index Dividend Future traded just 100 times in its first month, but picked up quickly – this year at least 200,000 contracts have been exchanged every month, with a record of 519,000 in May. Open interest at the end of May was 582,000 contracts.

Single stocks too

Eurex followed up in January by launching dividend futures on the individual companies in the Euro Stoxx 50. So far, 350,000 of these contracts have been traded.

In May came options on the Euro Stoxx 50 futures – they traded 4,750 times in their first month.

Since then the exchange has considered two national indices: the SMI for Switzerland and Dax for Germany.

Stuart Heath, Eurex’s product manager for dividend derivatives, says: “We’ve also looked at a couple of the more specialist indices that are selected on the basis of dividend payments, namely the Select Dividend 30 from the Euro Stoxx and the DivDax part of the German market.”

Heath, who became head of the exchange’s London office on July 1, agrees with De Pommerol that the market is underpinned by the long dividend exposure of banks that offer structured products. “They will always be interested in offsetting that risk and hedging in an efficient way, ” he says. “Our dividend products offer exactly this.”

Room to grow

Heath acknowledges that he cannot say for certain if dividend futures will carry on growing at the same speed.

He compares the roughly €6bn of open interest in Eurex’s index dividend futures with the approximately €60bn of dividends that Euro Stoxx 50 companies paid in 2009. “This might imply that that in effect only a tenth of the market is hedged,” he says.

Of course, not all investors are ever going to hedge their exposure, any more than their exposure to share prices. But that one tenth is perhaps a respectable figure.

For comparison, the Euro Stoxx 50 companies have a market capitalisation of about €1.5tr, yet open interest in Euro Stoxx 50 Futures at the end of June was €61bn – just 4%.

The true extent of dividend futures trading is probably larger, too. De Pommerol says there are “still some OTC derivatives out there in the market that have not expired and have not been novated into listed contracts”.

Heath suggests that the Euro Stoxx 50 dividend futures “account for probably around 50% of the European dividend swap market”.

New players

Over time, the mix of users has broadened, taking in a range from sophisticated hedge funds to more traditional asset managers. “Now that dividend futures have been brought on exchange, there are significantly more buy-and-hold-type investors such as pension funds,” says Heath. “It’s not just a specialist market.”

Heath believes there will be “an ongoing need not only to hedge their flows, but perhaps also to speculate on the growth of those flows”.

Encouraged by the success of its FTSE 100 product, NYSE Liffe, too, has been expanding its offering, adding dividend futures on the French CAC 40 index in December and on Amsterdam’s AEX index in May. O’Neill says both contracts are “coming along nicely ”.

The critical customer demand typically starts in Europe, O’Neill says, but these indices attract global interest, so he expects the product to be internationalised more and more.

“Typically, as an asset class becomes increasingly popular, one sees a wide range of players joining in,” says O’Neill. “And that’s really what makes a successful market, which we have definitely seen for this product since we launched in May 2009.”   

Asia warms to simplicity of trading on exchanges

In Asia, the Singapore Exchange became the first exchange to offer dividend futures in mid-June, when it launched its Nikkei Dividend Point Index Futures, based on dividends of companies in the Nikkei Stock Average.

Although the contract had been slated for listing in the third quarter, SGX beat the Tokyo Stock Exchange to the punch by launching first.

By June 22, five days after their debut, the futures’ open interest had reached ¥600m ($6.8m). On July 6, this had risen to over ¥8bn ($92m), with a total volume traded so far of ¥10bn.

The product complements SGX’s existing range of Nikkei products – its Nikkei 225 Index futures account for 30% of global trading of the contract.

“The contract provides price discovery, transparency and central clearing for over-the-counter dividend swaps,” says Chew Sutat, SGX’s head of market development. “As a result, we’ve seen some migration of OTC dividend swap activity to SGX.”

Although it is early days, Sutat said the exchange was “delighted” with international investors’ participation.

Janice Kan (pictured), senior vice-president of derivatives at SGX, says investors are using the contract to hedge and trade their Japanese dividend exposure, hedge the dividend element of structured products based on the Nikkei 225, to strip out dividends so they can maximise their exposure to share price appreciation, and to trade implied dividend yield spreads.  

In Japan, the TSE will list three new dividend futures, on the Nikkei 225, Topix and Topix Core 30 indices, starting on July 26.

Hong Kong Exchanges and Clearing is also considering launching dividend futures on its Hang Seng Index and Hang Seng China Enterprises Index.

“Dividend futures are definitely a phenomenon in Asia,” says Benjamin Dufour, head of forward trading for BNP Paribas’s global equities and commodity derivatives division in Tokyo. “The OTC dividend swap market on Nikkei has reached a very mature stage, with numerous counterparts involved, high liquidity, standardised contracts and now with more than five years of history.”

Dufour expects the market to grow “exponentially” as a result of the listed product at SGX, which he said had made an impressive start.

Most of the volume has been generated by what Dufour calls “regular actors” in the OTC dividend swap market, who started to shift trading to the exchange. As time goes on, he expects “new actors” to arrive, mainly those who did not have Isda documentation in place with the OTC dividend swap dealers.

Other attractions of the SGX product are price transparency and commitment of market makers such as BNP Paribas and Nomura.

The exchange talks continually to market participants about new product ideas, including dividend options and single stock dividend futures. O’Neill hints that announcements on these could be imminent.

Here to stay

Gareth Pickard, senior equities broker at MF Global, says: “Current demand is not in the league of some of the derivatives exchanges’ star products, such as the Euro Stoxx. However, they’re definitely not a fad and I feel they are here to stay.”

He argues that the example of BP shows why investors need to be able to hedge or speculate on dividends and the implications of changes in dividend expectations on indices like the FTSE 100.

“Portfolio managers and in particular income managers are naturally long dividends, and therefore they’re candidates to use these products as hedging tools,” says Pickard.

“Hedge funds have exposure to dividends through underlying positions and will want to use these products to speculate and hedge,” he adds. “Exotics, index and single stock desks at investment banks all have dividend exposure through their underlying delta hedges to options trades.”

Yet despite the organic need for hedging – and attractions of speculating on dividends – market players say the product’s growth will depend most of all on the amount of open interest there is in structured derivative products.

“If one has a large volume of structured derivatives on say the FTSE 100 or Euro Stoxx 50, naturally you will have a large interest in dividend futures, since there are both buyers and sellers,” says De Pommerol. “If not, then it’s likely to be a bit more complicated, as one does not have the natural seller interest.”

Pickard argues that most of the interest in exchange-traded dividend derivatives is speculative – and it’s a momentum-driven market.

“In general, if the market is up then dividends are also up, and conversely the reverse is true. Hence they act as a proxy,” he says. But equally, “There’s a real case for more widespread use as a hedging tool by income fund managers and others,” Pickard believes. “Hopefully this kind of activity will follow as markets become more liquid.”

As dividends are event-driven there is little movement day-to-day – prices tend to move in jumps as companies release information.

“This reduces the optionality in any possible trade, as there is little volatility to trade around short term,” Pickard explains. “Trades and ideas need to be researched and formulated well in advance of a possible event as there is – at present – very little liquidity. Consequently, the chance of getting a trade on as an event is unfolding is highly unlikely.”

Clean and neat

Nevertheless, the product has several attractions, Pickard argues, making it an “extremely clean way” to hedge or speculate on dividend risk.

“They are not capital-intensive, since they’re essentially CFDs and therefore subject to initial and variation margin – as opposed to payment in full,” he says.

The modern product is an improvement on the labour- and capital-intensive methods used before, including cash baskets and creating synthetic forwards.

Being listed on exchanges also means there is no counterparty default risk as the trades are cleared through a central counterparty.

Strategies involving dividend futures are fairly simple and straightforward. Investors use them as a delta one product – that is, one in which the derivative’s movements match those of the underlying. They can be used to go long and short outright, or to trade the calendar spread for year-on-year differentials.

However, Pickard stresses that the research involved in predicting changes in dividend expectations is “far from simple and is therefore the domain of the investment banks and research houses”.

This, he warns, could hinder the growth of liquidity as derivatives often rely on smaller market makers and individuals to provide competitive pricing and volume.

US getting there

Despite their healthy beginnings in Europe, dividend derivatives are at an earlier stage in the US. While the Securities and Exchange Commission has approved the trading of cash-settled dividend index options, the Commodity Futures Trading Commission has yet to sign off futures.

The Chicago Board Options Exchange is therefore leading the way. On March 5 it listed S&P 500 Dividend Index Options with a quarterly accrual period, for users with quarterly dividend exposures.

Then on May 25 came options on the S&P 500 Annual Dividend Index, initially with December 2010 and December 2011 expiries.

Paul Stephens, the CBOE’s head of institutional marketing (pictured), says that before the launch, “many of our customers told us that they felt it would take some time for dividend options to gain traction”.  

Longer term, the exchange is optimistic about the potential. Stephens says education is critical. “We’ve been working closely with global investment banks to get the word out to potential new customers, primarily institutional investors that have traded similar products OTC in the US, as well as OTC and listed in Europe,” he says.

The CBOE expects most of the early appetite to come from institutions looking to “capture the difference between implied and realised dividends”.

Both hedge funds and more traditional investment managers could become “significant” user bases, Stephens believes. “We also expect dividend options to appeal to any investors looking to hedge dividend exposures within their equity portfolios or within their equity index options positions – as a way to take views on the level and timing of future dividends.”

At NYSE Euronext, O’Neill is encouraged by the interest of other exchanges around the world, which he sees as confirming that the product has a long term future.

Pickard at MF Global would like the exchanges to do more. “At the moment it seems the costs being levied by the exchanges in these products are prohibitive to growth,” he says. “This is unusual, as to promote products the exchanges usually offer fee holidays or drastically reduced fees until growth is established.”

As a broker, MF Global wants to see developments to “encourage more aggressive pricing and better liquidity”.

But he’s a believer, too. “Growth is a definite possibility,” he says. “Though I doubt these products will eclipse contracts such as Euro Stoxx, Dax or FTSE futures and options, there is and will be a desire for them going forward.”