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 formulated alternate mechanisms to manufacture dividends by reference to three key stages in the dividend distribution process 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). In the JC’s view, as explained below, this is a classic case of overengineering. The only one you should ever need is the Paid Amount, which references the date of actual payment. Much of the fear, loathing and confusion in these definitions arises from sloppy drafting in relation to the other two options, which don’t make sense anyway.

Also, note this: the ex date and the record date logically come before the dividend payment date. They will usually precede it by weeks or even months. So 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.

If you elect Ex Amount or Record Amount, this would mean your equity swap would pay its Dividend Amount before the underlying share paid its actual dividend.

Spoiler: that’s stupid.

If you elect Paid Amount, it is conceivable 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”.