Template:Capsule equity derivative dividend payments: Difference between revisions

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 ===[[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. {{icds}}, 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).
+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. {{icds}}, with its yen for infinite particularity and optionality, has formulated alternate mechanisms to [[manufacturing|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]]'''<ref>Not to be confused with the {{eqderivprov|Dividend Payment Date}} in the {{eqdefs}}, being the date for the manufactured payment, not the payment of the underlying dividend itself.</ref> 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 {{eqderivprov|Dividend Period}}s are short (e.g., monthly), it is quite likely that the [[ex date]] and [[record date]] will fall in an earlier {{eqderivprov|Dividend Period}} then the [[dividend payment date]].
+None of them, in the [[JC]]’s purblind view, works.
-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 ''[[Declaration date|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''<ref>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]].</ref>. In fact, that is utterly antithetical to the very definition of the word “derivative”.
+The only one you should ever need is the {{eqderivprov|Paid Amount}}, as it references the date of actual payment of the underlying [[dividend]], and no {{eqderivprov|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 {{eqderivprov|Dividend Period}}s are short (e.g., monthly), it is quite likely that the [[ex date]] and [[record date]] will fall in an earlier {{eqderivprov|Dividend Period}} than the [[dividend payment date]].<ref>And may fall before the {{eqderivprov|Transaction}} has even ''started''.</ref>
+If you elect {{eqderivprov|Ex Amount}} or {{eqderivprov|Record Amount}}, this would mean your [[equity swap]] would pay its {{eqderivprov|Dividend Amount}} ''before'' the underlying share paid its actual dividend.
+Spoiler: that’s stupid.
+If you elect {{eqderivprov|Paid Amount}}, it is conceivable<ref>If a [[record date]] for a share is 1 January, the {{eqderivprov|Trade Date}} for a {{eqderivprov|Transaction}} on that share is 2 January, and the actual dividend payment date for that share is 10 January, then if you have elected “{{eqderivprov|Paid Amount}}”, to these purblind eyes, you would be obliged to pay “100% of the gross cash dividend per {{eqderivprov|Share}} paid by the {{eqderivprov|Issuer}} during the relevant {{eqderivprov|Dividend Period}} to holders of record of a {{eqderivprov|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.</ref> you could be expected to manufacture a dividend payment for a dividend whose [[record date]] fell ''before'' the {{eqderivprov|Trade Date}} of your [[equity swap]] {{eqderivprov|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 {{eqderivprov|Ex Amount}} or {{eqderivprov|Record Amount}} introduce ''arbitrary<ref> arbitrary because it is totally dependent on whether the [[ex date]] falls in the same {{eqderivprov|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.</ref> timing'' “[[basis]]” between the derivative and its underlying security, it also potentially introduces ''credit'' “[[basis]]”, because an underlying issuer which has ''[[Declaration date|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<ref>And note the {{eqdefs}} envisages {{eqderivprov|Dividend Amount}}s being paid on the {{eqderivprov|Cash Settlement Payment Date}}, which is at the end of the {{eqderivprov|Dividend Period}} — though many users ignore that and adopt a “pay-when-paid” approach, regardless of what the definitions say.</ref> — but ''[[credit]]'' basis is certainly not. ''Derivatives are not meant to guarantee the performance of the underlying securities they reference''.<ref>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]].</ref> In fact, that is utterly antithetical to the very definition of the word “derivative”.