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[1] itself (being the date on which the underlying dividend distributions actually hit holders’ bank accounts).
None of them, in the JC’s purblind view, works.
The only one you should ever need is the Paid Amount, as it references the date of actual payment of the underlying dividend, and no Equity Amount Payer with a sensible idea in its head will want to pay you sooner than that — but even that misses the significance to its payability of the earlier record date. You only are entitled to a dividend on the dividend payment date at all if you were the holder of record on the record date.
Much of the fear, loathing and confusion in these definitions arises from sloppy drafting in relation to this and 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 than the dividend payment date.[2]
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[3] you could be expected to manufacture a dividend payment for a dividend whose record date fell before the Trade Date of your equity swap Transaction.
Spoiler: that’s even stupider.
The point of a derivative is to replicate, as closely as possible, the economics of its reference asset. Not only does electing Ex Amount or Record Amount introduce arbitrary[4] 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[5] — but credit basis is certainly not. Derivatives are not meant to guarantee the performance of the underlying securities they reference.[6] In fact, that is utterly antithetical to the very definition of the word “derivative”.
- ↑ Not to be confused with the Dividend Payment Date in the 2002 ISDA Equity Derivatives Definitions, being the date for the manufactured payment, not the payment of the underlying dividend itself.
- ↑ And may fall before the Transaction has even started.
- ↑ If a record date for a share is 1 January, the Trade Date for a Transaction on that share is 2 January, and the actual dividend payment date for that share is 10 January, then if you have elected “Paid Amount”, to these purblind eyes, you would be obliged to pay “100% of the gross cash dividend per Share paid by the Issuer during the relevant Dividend Period to holders of record of a Share” even though the Hedging Party could not possibly have (deliberately) held a hedge yielding that dividend on the record date, since the trade did not exist at that point in time.
- ↑ arbitrary because it is totally dependent on whether the ex date falls in the same Dividend Period as the actual payment date, which in turn will be a function of the registrar’s schedule and nothing to do with the Issuer.
- ↑ And note the 2002 ISDA Equity Derivatives Definitions envisages Dividend Amounts being paid on the Cash Settlement Payment Date, which is at the end of the Dividend Period — though many users ignore that and adopt a “pay-when-paid” approach, regardless of what the definitions say.
- ↑ Okay I realise that seems not to be true for credit derivatives. But even there, the credit protection “buyer” is effectively short the derivative exposure. It is simply confused because in the classic case, the protection “seller” was an investor buying a CDO which is an instrument which securitises a short credit derivative.