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 REALIZED VOLATILITY IS LOWER THAN EQUITY REALIZED VOLATILITY 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:
REALIZED DIVIDENDS DECLINE LESS THAN EQUITIES 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. IMPLIED DIVIDENDS CAN DECLINE MORE THAN EQUITIES 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. IMPLIED DIVIDENDS ARE THE UNDERLYING OF OPTIONS ON DIVIDENDS 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). DIVIDENDS SHOULD HAVE HIGHER SKEW THAN EQUITIESSkew 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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Trading Dividend Vol.
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