Dividend - Equity Derivatives Provision

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2002 ISDA Equity Derivatives Definitions
A Jolly Contrarian owner’s manual

Section 10.1 in a Nutshell
Use at your own risk, campers!

10.1. “Dividend Amount” means a Share’s Record Amount, Ex Amount or Paid Amount, as specified in the Confirmation and adjusted to cater for concentrations or dilutions under Section 11.2.

10.1(a)Record Amount” means 100% of the gross cash dividend per Share declared by the Issuer to Shareholders on any record date during the Dividend Period.
10.1(b)Ex Amount” means 100% of the gross cash dividend per Share declared by the Issuer to Shareholders of record, where the Shares commence trading “ex-dividend” during the Dividend Period.
10.1(c)Paid Amount” means 100% of the gross cash dividend per Share paid during the Dividend Period to holders of record of a Share.

Any “gross cash dividend” represents the sum before any tax withholding and excluding any tax imputations, credits, refunds or deductions granted or levied on the dividend, and excluding any Extraordinary Dividends and Excess Dividend Amounts.
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Section 10.1 in full

Section 10.1. Dividend Amount. “Dividend Amount” means, in respect of the relevant Share, the related Dividend Period and the related Dividend Payment Date, the Record Amount, the Ex Amount or the Paid Amount, as specified in the related Confirmation, or any other amount determined as provided in the related Confirmation or included as part of an adjustment pursuant to Section 11.2.

10.1(a) Record Amount. “Record Amount” means, in relation to a Dividend Amount, 100% of the gross cash dividend per Share declared by the Issuer to holders of record of a Share on any record date occurring during the relevant Dividend Period.
10.1(b) Ex Amount. “Ex Amount” means, in relation to a Dividend Amount, 100% of the gross cash dividend per Share declared by the Issuer to holders of record of a Share where the date that the Shares have commenced trading “ex-dividend” on the Exchange occurs during the relevant Dividend Period.
10.1(c) Paid Amount. “Paid Amount” means, in relation to a Dividend Amount, 100% of the gross cash dividend per Share paid by the Issuer during the relevant Dividend Period to holders of record of a Share.

Any “gross cash dividend” shall represent a sum before the withholding or deduction of taxes at the source by or on behalf of any applicable authority having power to tax in respect of such a dividend, and shall exclude any imputation or other credits, refunds or deductions granted by any applicable authority having power to tax in respect of such dividend and any taxes, credits, refunds or benefits imposed, withheld, assessed or levied thereon. In addition, “gross cash dividends” shall exclude Extraordinary Dividends and Excess Dividend Amounts, if any, unless otherwise provided in the related Confirmation.
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Resources and navigation

Resources About the Equity Derivatives Definitions | (full wikitext) | (nutshell wikitext)
Hot topics The Triple Cocktail | Cancellation and Payment | Calculation Agent
TOC | 1 General Definitions | 2 Option Transactions | 3 Exercise of Options | 4 Forward Transactions | 5 Equity Swap Transactions | 6 Valuation | 7 Settlement | 8 Cash Settlement | 9 Physical Settlement | 10 Dividends | 11 Adjustments and Modifications | 12 Extraordinary Events · 12.8 Cancellation Amount · 12.9 Additional Disruption Events · 12.9 ADEs · 12.9(b) Consequences of ADEs | 13 Miscellaneous

Index — Click ᐅ to expand:

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Section 10.1. Dividend Amount

10.1(a) Record Amount
10.1(b) Ex Amount
10.1(c) Paid Amount

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Summary

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:

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] timingbasis” between the derivative and its underlying security, it also potentially introduces creditbasis”, 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”.
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General discussion

The timing of dividends

There are four crucial dates: in order, these are the “declaration date”, the “ex-dividend date”, the “record date”, and the “Dividend Payment Date”.

  • Declaration date: The declaration date (also called an announcement date is the date on which the issuer announces there will be a dividend. They usually happen quarterly, for those stocks which are regular dividend payers. This comes first. The dividend declaration will include the size of the dividend (the Dividend Amount), the ex-dividend date (being the last date on which, if you buy the stock, you get the dividend), and the Dividend Payment Date — the date on which a dividend is actually paid. Timings are likely to be (these are indicative — I just made them up okay):
  • Ex-dividend date actually keys off the record date, and is set based on stock exchange rules — usually a business day before the record date. If you buy a stock on or after its ex-dividend date, you won’t get the dividend because the trade won’t settle until after the ...
  • Record date, being the date you actually have to be on the register of shareholders to qualify for the dividend, which will be paid to whoever was the holder of record on the record date, whether or not they have subsequently sold the share, on the
  • Dividend payment date which may be as much as a month or more after the original dividend declaration date.

Interest and accruals

While the definitions provide that the Equity Amount Payer must manufacture Dividend Amounts on the Cash Settlement Payment Date, (typically at the end of a Dividend Period) and therefore structures in a period between receipt of underlying and payment on the swap, the definitions do not provide for any interest accrual over that period.

In practice, users tend to “pay when paid”, settling Dividend Amounts the business day following receipt on the underlying, notwithstanding the text of the 2002 ISDA Equity Derivatives Definitions. No-one complains about this. Indeed, we imagine no-one is any the wiser. If you are anything like the JC, you will quietly wonder why we bother negotiating contracts in the first place, if operations personnel are just going to ignore them in practice. If you are an operations person, you may quietly wonder exactly the same thing.

Dividends on Index Transactions? No, sir. But yes, sir.

We shouldn’t really need to say it, but we will: You don’t — well ~ cough ~ shouldn’t — get dividend payments on an Index Transaction. The Index calculation methodology will either replicate the effect of dividend reinvestment on Index constituents, by proportionately re-weighting constituents when they pay dividends — in which case you will get the effect of those dividends just through “price return” of the Index level — or it won’t, in which case you won’t get the effect of those dividends, BECAUSE YOU BOUGHT A DERIVATIVE OF AN INDEX THAT DOESN'T REPLICATE THE EFFECT OF ANY DIVIDENDS.[7]

Either way, the dividend provisions of the 2002 ISDA Equity Derivatives Definitions aren’t — well ~ cough ~ shouldn’t be — relevant to Index and Index Basket Swap Transactions. So they don’t really countenance the idea of an Index paying through dividends. While, in the Russian-doll defined terms schema confected by ISDA’s crack drafting squad™ an Index Swap Transaction is a kind of Equity Swap Transaction, and therefore can have a Type of Return applied to it, when you dive down the rabbit hole, through the Total Return star-gate, along the Re-investment of Dividends axis and into the Dividend Amount portal, you hit the hard black nothingness of dark energy: A Dividend Amount is defined, of course, by reference to a Share’s Record Amount, Ex Amount or Paid Amount, and not that of an Index, for the compellingly straightforward reason that Indices are abstract numbers. They don’t pay dividends.

Now ISDA’s crack drafting squad™ made a half-hearted swipe — actually, it a was more like a full-blooded, half-hour long drubbing — in one of the Pan-Asia MCAs to build in manufactured dividends to Japanese index products, but it is fiendishly complicated, not to mention wrong-headed, and no-one uses it as far as we know.

However.

There is a fairly common market practice, for indices that don’t re-weight to replicate dividend reinvestment, for dealers to manufacture dividends on the Index constituents anyway. This is because a common means of hedging indices is by buying the underlying stocks, so since the dealer is getting the cashflows in and can pay them out. This is hard to reconcile with the drafting of the 2002 ISDA Equity Derivatives Definitions, unless either (i) for Index transactions, you rather wilfully deemShares” to mean “constituents of the Index”, or (ii) you treat the Index Transaction as really a dynamic custom Share Basket Swap Transaction. Your front office guys won’t like that suggestion, so do you know what the JC’s approach is? Just leave it. This is one of those beautiful places where the lawyers — who have only the faintest grasp of that the front office does at the best of times — do one thing, and the business — which broadly could not care a row of buttons what legal contracts say until it suddenly all goes Pete Tong — does another, ne’er the twain meet, and the respective groups carry on in blissful ignorance of the a gaping conceptual chasm between them.

And speaking of gaping chasms, you know what I’m going to say now, don’t you?
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See also

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References

  1. 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.
  2. And may fall before the Transaction has even started.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. The S&P 500 index, for example, does not factor in any dividend payments. Apparently.