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 elected 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.

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 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”.

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.