Dividend Volatility Trading
Derivatives-based Portfolio Solutions


If a constant dividend yield is assumed, then the volatility surface for options on realized dividends should be identical to the volatility surface for equities. However, as companies typically pay out less than 100% of earnings, they have the ability to reduce the volatility of dividend payments. In addition to lowering the volatility of dividends to between ½ and ⅔ of the volatility of equities, companies are reluctant to cut dividends. This means that skew is more negative than for equities, as any dividend cut is sizeable. Despite the fact that index dividend cuts have historically been smaller than the decline in the index, imbalances in the implied dividend market can cause implied dividends to decline more than spot.

Dividend yields are often thought of as mean reverting, as they cannot rise to infinity nor go below zero. If the dividend yield is constant, then the dividend volatility surface will be identical to the equity volatility surface. However, dividends’ volatility tends to be between ½ and ⅔ of the volatility of equities, depending on the time period chosen. This discrepancy is caused by two effects:
  • Dividend volatility suppressed by less than 100% payout ratio. Companies typically pay out less than 100% of earnings in order to grow the company. As corporates are normally reluctant to cut dividends, they will simply increase the payout ratio in a downturn. This is done both to avoid the embarrassment of cutting a dividend, but also as in a downturn there are likely to be limited opportunities for growth and, hence, little need to reinvest earnings (typically costs and investment are cut in a downturn). If the economy is growing and earnings increasing significantly, then companies will normally increase dividends by less than the jump in earnings. This is done in case the favourable environment does not last or because there are attractive opportunities for investing the retained earnings.
  • Equity volatility is too high compared to fundamentals. On balance, academic evidence suggests that equity volatility is too high compared to fundamentals such as dividend payouts. Statistical arbitrage funds can normally be expected to eliminate any significant short-term imbalances. However, their investment time horizon is normally not long enough to attempt to reduce the discrepancy between equity and fundamental volatility on a multiple-year time horizon.

In 140 years of US data, there has never been a larger decline in index realised dividends than the index itself. This is because in a bear market certain sectors are affected more than others, and it is the companies in the worst affected sectors that cut dividends. For example, in the 2000-03 bear market, TMT was particularly affected. Similarly, the credit crunch has hit financials and real estate the hardest. As companies are loath to cut dividends, the remaining sectors tend to resist cutting dividends. This means that, while at a stock level dividend declines can be greater than equity declines (as dividends can be cut to zero while the equity price is above zero), at an index level realised dividends only experience an average decline of half to two-thirds of the equity market decline.

Before the credit crunch, some participants believed that dividends decline less than spot if spot falls, as corporates are reluctant to cut dividends. This is only true at the single-stock level and only for small declines. If a single stock falls by a significant amount, the company will cut dividends by a larger amount than the equity market decline (as dividends will be cut to zero before the stock price reaches zero). A long dividend position is similar to long stock and short put, where the strike is very dependent on market sentiment and conditions. For severe equity market declines, implied dividends can decline twice as fast as spot. This disconnect between realised and implied dividends occurs when there is a large structured product market (markets such as the USA, which have few structured products, do not act in this way).

Structured products can cause dividend risk limits to be hit in a downturn. Typically, the sale of structured products not only causes their vendor to be long dividends, but this long position increases as equity markets fall. For example, autocallables are a particularly popular structured product as they give an attractive coupon until they are automatically called (which occurs when the equity market does not fall significantly). As the maturity effectively extends when markets decline (as the product is not called as expected), the vendor becomes long dividends up until the extended maturity. As all investment banks typically have the same position, there are usually few counterparties should a position have to be cut. This effect is most severe during a rapid downturn, as there is limited opportunity for investment banks to reduce their positions in an orderly manner.

As it is not possible to hedge an option on dividend with realized dividend (they are not traded), the volatility of the underlying implied dividend is the key driver of an option on dividend’s value. While realized dividends are less volatile than equities, implied dividends can be more volatile than equities. The volatility of implied dividends is also likely to be time dependent, with greater volatility during the reporting period when dividends are announced, and less volatility at other times (particularly for near dated implied dividends).

Skew can be measured as the third moment (return is the first moment, variance is the second moment). Equities have a negative skew, which means the volatility surface is downward sloping and the probability distribution has a larger downside tail. The mathematical definition of the third moment is below. Looking at annual US dividend payments over 140 years shows that skew is more negative for dividends than equities. This difference in skew narrows if the third moment for bi-annual periods or longer are examined, potentially as any dividend cuts companies make are swiftly reversed when the outlook improves.
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