Options on Dividends – An Introduction
Dr. Akilesh Eswaran
akilesh.eswaran@db.com
May 2011
Introduction
 Options on Dividend Futures are a new listed product offered by Eurex since May 2010
 Option on dividends are listed with annual expiries upto 2019
 Number of strikes available vary by expiry with additional strikes listed for 2012, 2013 and 2014
 Contract value is EUR 100 per index dividend point of underlying Euro STOXX 50 Index Dividend Futures
1
Contract Specification
Option on Dividend Contract Specification
2
Uses of Options on Dividends
Why trade options on dividends?
 Leverage
 Efficient hedge for portfolio risk
 Exploit supply demand inefficiencies
 Opportunities for relative value trading
 Delta1 Overlay strategies
3
Pricing Option on Dividends
 Dividend Future is assumed to follow a Log-normal distribution, i.e. the same stochastic process as the index
 Options on dividends can be priced using a Black Scholes Model assuming a Flat Forward
 Value of a call option at time ‘t’ (C(S,t)) using a flat forward Black Scholes model is the following:
C(S , t )  (S  N (d1 )  K  N (d2 )) er (T t )
S
2
ln ( ) 
 (T  t )
K
2
d1 
 T t
S
2
ln ( )   (T  t )
K
2
d2 
 T t
where,
N(x) is the cumulative distribution function of a standard normal distribution
S is the Spot Dividend
K is the Option Strike
T-t is the Time to Maturity
σ is the Volatility of dividend returns
4
Volatility of Dividend Futures
 The most important determinant of the option price is the volatility assumption
 A key difference between dividend futures and equity index is that dividends realize.
 Dividends while initially unknown are announced and paid. The fact that dividends become known has major
implications for option pricing
 Dividend realized volatility trend towards zero as the maturity of the future approaches
 The dividends referenced by 2011 contract are paid from earnings accrued during the 2010 fiscal year.
3M Realized Volatility of Dec-11 Div Futures
3M Realized Volatility of Dec-14 Div Futures
35.00
45. 00
40. 00
30.00
35. 00
25.00
30. 00
20.00
25. 00
15.00
20. 00
15. 00
10.00
10. 00
5.00
0.00
Mar-09 Jun-09
5. 00
0. 00
Oct-09
Jan-10
Apr-10
Jul-10
Nov-10
Feb-11 May-11
M ar -09
5
J un- 0 9
Oct-09
J a n- 1 0
A pr - 1 0
J ul - 1 0
N ov - 1 0
Fe b- 1 1
M ay-11
Historical Volatility of Dividend Futures
The dividends can be more volatile than the equity index during the period of market stress and when risk trades are
unwound.
Historical Implied vol of Dividends
40
ATM
Volatility
Index
Dividend
ATM Implied Volatility
35
30
25
Dec-14
23.0
12.0
24.0
17.5
24.1
20.0
The ratio of Index vol to div vol
approaches zero as the volatility of the
dividend futures decline but it can be
above the index volatility even during
periods of relative calm such as
summer 2009
15
10
0
May-10
Jul-10
Dec-11
Sep-10
Dec-12
Nov-10
Jan-11
Dec-13
Mar-11
May-11
E-STOXX50 3M IV
3M Realized Volatility Ratio of Dec’11 Div to SX5E
3M Realized Volatility Ratio of Dec’14 Div to SX5E
1.40
1.40
1.20
1.20
1.00
1.00
0.80
0.80
0.60
0.60
0.40
0.40
0.20
0.20
Jun-09
Dec-13
20
5
0.00
Mar-09
Dec-12
Oct-09
Jan-10
Apr-10
Jul-10
Nov-10
Fe b-11
0.00
M ar-09
May-11
6
Jun-09
Oct-09
Jan-10
Apr-10
Jul-10
Nov-10
Fe b-11
M ay-11
Beta of Dividend futures
 The figure below shows the beta of dividend futures to the SX5E Index including only the days where the index
moved by at least 2% (either up or down)
 The important point to note is that the beta of dividend futures to the index itself has historically been higher on the
downside than on the upside
 This implies that Option on Dividends can be an attractive alternative to hedge downside risk
Beta of Dec’14 Div vs. SX5E index for index moves > 2%
7
Trading Dividends on other Indices
 The most common way of trading dividends is buying Futures outright
 E-STOXX 50 expected dividend growth is depressed compared to S&P 500 and FTSE
 Macro and structural factors have pressured European implied growth
 Nikkei 225 has a similar structured products overhang as the E-STOXX 50
 Difficult to play convergence due to wide bid/offer and limited liquidity on the S&P 500 dividend swaps
Div contract value rebased as 2010 level
.
Dividend Futures
160
150
140
130
120
110
100
90
80
2010
2011
2012
E-STOXX 50
2013
2014
2015
S&P 500
2016
FTSE 100
Source: DB estimates. Levels are as of 17-Nov-10
8
2017
2018
Nikkei 225
2019
Trading Dividends
Long E-STOXX 50 dividend futures for ‘safer’ equity exposure
 Dividend contracts trade at a discount to estimates, div payments are typically more stable than equity prices
 Consider buying dividend futures to maintain equity exposure with potentially less volatility than a long stock position
 Contracts with varied maturities allow for speculation medium-to-long growth expectations
 A long div futures position may incur material losses if implied or realized dividend decline (can use options instead)
E-STOXX 50 Historical and Expected Dividend Growth
160
30%
140
20%
120
80
0%
60
-10%
40
-20%
20
Actual Paid Dividends
Year
Dividend Futures Levels
Dividend Growth Rate
Sources: DB , Bloomberg. *As of 17-Nov-10
9
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
-30%
1999
0
Growth Rate
Index div points
10%
100
Trading Dividends – some trade ideas
 Dec-12 Capped bullish risk reversal: Short 118 put, long 125 call, short 135 call for 0 premium.
- Pull to fair value of dividends expected in the next 6 to 8 months => quick Mark to market gains
 Dec12 Short 118 put vs Long 127 call for zero premium
 Short 2 X Dec12 118 puts to buy a Dec13 129 Call
- Dec13 dividends trade at around a 27% discount to analyst fair value estimates
Some other prices commonly traded structures on Option on Dividends:

Call/Put option
ATM Call

Dec-13
12
Dec-14
16.9
Zero Premium Bullish Risk Reversal: Client Sells OTM Put to Buy OTM Call
Strike

Dec-12
6
Dec-12
Dec-13
Dec-14
100/131
110/123
110/116
Zero Premium Call Spread Collar: Client Sells Put to buy Call Spread
Strikes
Dec-12
118 / 125 / 135
Dec-13
110 / 120 / 145
Ref Levels: Dec-12: 123, Dec 13: 117, Dec14: 113
10
Dec-14
105 / 115 / 150
Trading Dividends – exotic options
Dividend/Spot Exotic Option
 2013 dividends offer a large discount compared to
estimates and to last realized dividends
 However, buying Dec 13 dividends outright can be
risky as:
• Implied dividends tend to fall even more than
spot on the downside due to lower liquidity and
market bias (most active players being long)
• the longer the maturity the higher the uncertainty
on the Dividend and the higher the downside risk
 Furthermore buying a simple call on Dec 13 dividends
can prove expensive compared to reasonable
expected upside
Indicative Terms
Idea
 Maturity – Dec ’13 / Currency EUR
 If SX5E does not hit 120% of its initial value (continuous
observation) till Dec ‘12
- Client receives Max(0, Dec ‘13 Dividends – 117)
- Else, 0%
 Indicative offer at 9.0 vs. 12.0 on the vanilla call for ref
2013 Dividends at 117
 In a weak recovery scenario we could keep seeing
solid corporate profits of large caps and growing
dividends…
160
5%
140
0%
120
-5%
100
-10%
80
-15%
60
-20%
40
-25%
20
-30%
0
-35%
2010
RISK : Investor might lose all the premium
Please note that all levels provided in this presentation are indicative and for
illustration purposes only.
2011
2012
Dividend contract year
Dividend Futures Level
11
2013
Analyst Estimates
Discount
Futures discount to estimates
SX5E Dividends – Futures vs. Analyst’s Estimates
Index div points
 ….while poor macro indicators, less leverage and high
unemployment would prevent a strong market rally
(SX5E already up 55% from the lowest level seen
during credit crisis in March ‘09)
Deutsche Bank’s Dividend Research Offering
12
An comprehensive dividend research offering from DB

An extensive library of dedicated dividend research.
Recent publications & presentations include:
 May-11: E-STOXX 50 Dec-12 Dividend Scenarios
 Mar-11: Derivatives Monthly April – Dividend
Season Trades
 Feb-11: Dividends as an Asset Class
 Sep-10: The fundamentals of dividend futures and
The dynamics of dividend futures
 Jul-10: The value in European dividends

Weekly E-STOXX 50, FTSE & SPX index dividend
monitors

On-line dividend analysis tools

Bespoke analysis, including bottom-up and top-down
forecasts

Database of European dividend news and estimate
changes
13
Dividend analysis available on-line at eDerivatives

Valuation: Plot historical actual dividend levels
or dividend yields

Market dynamic: Plot rolling maturities or actual
expiration

Sensitivity analysis: Check implied dividend
volatility or its beta against market index

Cross asset: Compare dividend and bond yields
across maturities

Implied growth: View market expectations for
future dividend growth and compare implied
growth rates among major indices
The world of derivatives at http://eDerivatives.db.com
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Contacts
 Equities Derivatives Group - Europe
̶ London
- Tel: +44 20 7547 1343
̶ Frankfurt
- Tel: +49 69 9103 8434
̶ Akilesh Eswaran : akilesh.eswaran@db.com
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Disclaimer
HYPOTHETICAL DISCLAIMER
Backtested, hypothetical or simulated performance results discussed herein have inherent limitations. Unlike an actual performance record based on trading actual client
portfolios, simulated results are achieved by means of the retroactive application of a backtested model itself designed with the benefit of hindsight. Taking into account historical
events the backtesting of performance also differs from actual account performance because an actual investment strategy may be adjusted any time, for any reason, including a
response to material, economic or market factors. The backtested performance includes hypothetical results that do not reflect the reinvestment of dividends and other earnings
or the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid. No representation is made that any
trading strategy or account will or is likely to achieve profits or losses similar to those shown. Alternative modeling techniques or assumptions might produce significantly different
results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor guarantee of future returns. Actual results will vary, perhaps materially,
from the analysis.
Acting at arm's length. Pricing levels and valuations published herein are indicative and they and any other information are for information purposes only.
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