Template:Capsule equity derivative dividend payments

Manufacturing dividends under an equity swap

You will quickly come to realise that the equity derivatives definitions regarding payment of dividends might as well have come from a dungeon deep in the brain of MC Esher. ISDA’s crack drafting squad™, with its yen for infinite particularity and optionality, has provided for at least three mechanisms of manufacturing dividends: by reference to three key stages in the process of distributing dividends in an underlying security: the record date (being the date on which a holder of record becomes entitled to a dividend payment), the ex date (being the date on which the underlying shares trade clean of the dividend payment in the market, which will be one settlement cycle before the record date), and the dividend payment date itself (being the date on which the underlying dividend distributions actually hit holders’ bank accounts).

And note this: the ex date and the record date logically come before the dividend payment date, and usually will precede it by weeks or even months. If your Dividend Periods are short (e.g., monthly), it is quite likely that the ex date and record date will fall in an earlier Dividend Period then the dividend payment date.

This would mean the equity derivatives transaction would pay its dividend amount before the underlying share paid its actual dividend. When you consider the point of a derivative is to replicate the economic effect of its reference asset, you will quickly realise that this is a stupid outcome. Not only does this introduce timing “basis” between the derivative and its underlying security, it also potentially introduces credit “basis”, because an underlying issuer which has declared a dividend may not ultimately be able to pay it — if it has become insolvent in the meantime, which could be a period of months. Now some timing basis between a derivative and its underlying is inevitable — the derivative payment will lag the underlying payment — but credit basis is certainly not. Derivatives are not meant to guarantee the performance of the underlying securities they reference. In fact, that is utterly antithetical to the very definition of the word “derivative”.