FE 5110 Financial Engineering Project

Index Dividend Futures: Pricing Strategy and Investment Analysis

Priyanka Bhandari A0069105J

Contents
Executive Summary................................................................................................................................. 3 Chapter 1 Introduction ........................................................................................................................... 4 Chapter 2 Pricing and Analysis Methodology ......................................................................................... 7 Chapter 3 Observations and Discussion ................................................................................................. 9 3.1 Pricing Analysis for Eurostoxx 50 Index (Eurex) ............................................................................ 9 3.2 Pricing Analysis for Nikkei 225 Index (SGX)................................................................................. 12 3.3 Observations ............................................................................................................................... 15 3.4 Implications ................................................................................................................................. 16 3.4.1 Arbitrage Opportunities ....................................................................................................... 16 3.4.2 Low Risk Investment Opportunities ..................................................................................... 19 Chapter 4 Conclusions .......................................................................................................................... 22 Chapter 5 References............................................................................................................................ 24

Executive Summary
The focus of this project is the equity derivative class known as Index Dividend futures; this security allows investors to hedge against dividend risk by buying futures on the total dividend payout of an index for a particular calendar year. These products evolved from OTC dividend swaps and were initially offered on Eurex in June 2008 and have since been traded in increasing volumes at exchanges around the world. This project focuses on the fair pricing and investment opportunities associated with dividend futures, using Eurex Eurostoxx 50 as well as locally traded SGX Nikkei 225 dividend index futures as examples. The put- call parity is utilised as a tool for pricing dividends that are implied by traded option prices; these implied dividend prices are then compared with the dividend futures prices to study whether mispricing is present in the market, and if so, what whether they lead significant arbitrage or investment investors. Results indicate that significant mispricing is present in the case of both the selected securities. Eurostoxx 50 dividend futures are seen to have more significant and systematic mispricing as compared to dividends implied by replicating portfolios, where in the case of the SGX Nikkei 225 index dividend futures, mispricing does not follow any systematic trends. Additionally, arbitrage can arise from mispricing between dividends implied through replicating portfolios and divided futures. However, as is typical of arbitrage opportunities, these are limited, fleeting and offer a modest payout at best. On the other hand, low- risk investment opportunities are seen to be more prevalent, allowing investors to make significant profit from relatively low dividend risk.

Chapter 1 Introduction
Many new and innovative financial instruments have flooded the derivative market in recent years. New derivatives range from increasingly complex options, such as Mountain Range and Rainbow options, to products that break into new realms, such as Weather Derivatives. One such derivative is the dividend future, which is the focus of this project. Dividend futures are derivatives that track the dividends paid either by single companies (single stock dividend futures) or all the companies in an index (index dividend futures) in a calendar year. These derivatives evolved from over-the-counter dividend swaps, which began flourishing in the early 2000s. Dividend swaps, like interest rate swaps, consist of a fixed leg and a floating leg. Most common forms of dividend swaps involve a set number of legs, where the buyer pays a fixed amount of cash in exchange for the realized dividend on a stock, combination of stocks, or index. Variations may include the seller receiving options on the underlying instead of cash. Fixed Amount Buyer Realized Dividends on Stock(s) or Index
Figure 1 Dividend Swap

Seller

Dividend futures, like dividend swaps, enable investors to benefit from or hedge against dividend risk. Dividend futures contracts, like other equity futures, can be purchased from the exchange. When a market participant buys a contract expiring at the end of a certain year, for example December 2012, they are entitled to receive the dividends that will be realized between December 2011 and December 2012. Conversely, by shorting dividend futures, investors can hedge against the uncertainty associated with dividend payouts by receiving a fixed amount today. Figure 2 shows the prices at which dividend futures on the Eurostoxx 50 Index are traded on Eurex.

Eurostoxx Dividend Futures Contracts

150 125 100 75 50 25 0 3/09 6/09 9/09 3/10 6/10 9/10 3/11 6/11 9/11 3/12 6/12 9/12 12/09 12/10

DEDZ2 (Expiring Dec 2012) DEDZ3 (Expiring Dec 2013) DEDZ4 (Expiring Dec 2014) DEDZ5 (Expiring Dec 2015) DEDZ6 (Expiring Dec 2016)

Figure 2 Eurostoxx Dividend Futures Prices

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Dividend futures began appearing in the exchange traded market in June 2008, with the launch of Eurostoxx 50 Index Dividend Futures, and have grown significantly since then. They have been introduces into markets around the world (FTSE100, SGX Nikkei225) and have been trading in everincreasing volumes.

Eurex Eurostoxx 50 Index Dividend Futures

Contracts (Thousands)
2500 2000 1500 1000 500 0 Q2 2008 Q3 2008 140 120 100 80 60 40 20 0 Volume Open Interest Q4 2008 Q1 2009 Volume Open Interest

Figure 3 Trading Volumes and Open Interest on Eurostoxx 50 dividend futures (Eurex)

SGX Nikkei 225 Index Dividend Futures

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Figure 4 Trading Volumes and Open Interest on Nikkei 225 dividend futures (SGX)

Stock and index futures have existed for decades, as a means to hedge against changing equity prices, but relatively little attention has been given to dividend risk until now. Although dividend risk is not as significant as equity risk, there have been cases in recent years of companies cancelling dividends in response to adverse economic events; for example, BP (part of FTSE 100) cancelled three of their 2010 dividends in response to the Gulf of Mexico oil- spill. Additionally, analysts and speculators widely expect Nokia (part of Eurostoxx 50) to cancel their dividends for 2012, as part of dealing with negative cash flow. Hence, protecting dividends may be an important strategy for many

Q2 2010

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investors, especially fund managers who are naturally exposed to dividend risk through their positions. Since dividend futures are relatively new products and are not as heavily utilised as more established derivatives, extensive literature and documentation does not exist regarding their fair pricing and investment potential. The objective of this project is to develop a pricing strategy to determine the arbitrage-free price of index dividend futures; furthermore, the calculated prices will be compared with the observed market prices to analyse the presence and nature of mispricing. Additionally, this project will analyse whether market mispricing gives risk to arbitrage and/ or investment opportunities for market participants. Academic literature on this topic is sparse; two studies have previously been conducted on Eurex Eurostoxx 50 dividend futures. The first is by Wilkens and Wimschulte [1] and the other by Barakat and Coscas [2], both in 2009. Both studies conclude that significant discrepancies exist between the prices of dividend implied by options and the price of dividend futures. However, a crucial methodological oversight exists in both papers (this will be elaborated upon in the next chapter), and both studies were conducted over brief periods of time in the first year that the index dividend futures were listed on Eurex. Therefore, this project is an extension and improvement of their work; an important methodological flaw is corrected and analysis is carried out over a longer period of time and also diversified to include the local SGX market.

Chapter 2 Pricing and Analysis Methodology

Index dividend futures are prices are meant to track the expected total dividends to be received in a calendar year; this is undoubtedly affected by the trend in the indexs dividend payouts over recent years as wells as projected expectations of payout from companies based on economic conditions and events. However, another way that outstanding dividends between the observation date and maturity are expressed in the market is through the put-call parity in options pricing. For dividend paying equities, the put-call parity dictates that the price of dividends receivable between the observation date, t, and the maturity, T, is given by:

where is the sport price of the index on the observation date, and and are the prices of put and call options, respectively, on the observation date t, maturing at time T, struck at a strike price K. is the risk- free interest rate at which investors can borrow cash between the observation and maturity dates. It is reasonable to expect that if the market is efficient and all available information is reflected in market prices, then the present value of dividends reflected by option prices and dividend futures should coincide. The tests carried out to rigorously test this hypothesis are detailed below. First, data was collected from Bloomberg as follows: 1. Last transacted daily prices for EuroStoxx 50 Index from 26 June 2008 (launch of Eurostoxx 50 dividend futures on Eurex) - 12 October 2012 2. Last transacted daily prices for Call and Put prices on EuroStoxx 50 Index The maturity of the Calls and Puts should be the same, and should further coincide with expiry date of EuroStoxx 50 Index Dividend Futures Collect Call and Put prices for a range of strike prices, 3. Collect Euribor 12mth interest rate from 26 June 2008- 12 October 2012, to act as the risk-free interest rate 4. Last transacted daily prices for EuroStoxx 50 Index Dividend Futures, with expiry dates ranging from December 2012- December 2016, from 26 June 2008- 12 October 2012 Following data collection, the implied dividend prices were calculated through replication using the put- call parity: 1. Implied Dividends are calculated as follows:

2.

Caveats: 7

a. When using calls and puts of maturities longer than December12, the implied value of dividends of preceding years must be subtracted. For the year 20013, we have:

Similarly, for the year 2014, we have:

b. Implied dividends for the calendar year ending in December2012 are inaccurate for our purposes for the following reasons: From 26 June 2008 to 31 December 2011, dividends implied by the put-call parity will include dividends to be paid out prior to calendar year 2012 From 1 Jan 2012 onwards, the implied dividends do not reflect the full amount of dividends that will be paid out in the year 2012, because as the year progresses, companies in the index will give out dividends, hence reducing the implied dividends to be received. Therefore, 2012 implied dividends cannot be compared directly with 2012 dividend futures, but will be instructional to study nonetheless; they will be discussed in greater detail in the next chapter. In both the previous studies done on dividend pricing, this step was overlooked, or if some adjustments were done to compensate for this inconsistency, it was not disclosed. Once the market- implied dividends for calendar years 2013- 2016 have been calculated, they will be compared to the traded futures prices for those years. The analysis serves to address the following: Whether the replicated prices and observed market prices agree If mispricing occurs, what are its trends and characteristics What are the implications of mispricing: whether there are opportunities for investors to realize arbitrage or low- risk investment opportunities as a result of mispricing.

Chapter 3 Observations and Discussion

In this chapter, we will analyse the implied dividend prices and dividend futures prices for contracts expiring from December2013- December2016 inclusive. Following analysis, we will evaluate if significant mispricing exists, and whether arbitrage and investment can be realized as a result of mispricing.

3.1Pricing Analysis for Eurostoxx 50 Index (Eurex)

First, using data from call and put options expiring in December 2012, the cumulative implied dividends between different observation dates (from 16 June 2008 to 10 October 2011) to maturity are calculated. As mentioned in the previous section, the market implied dividends for contracts expiring in December 2012 are not directly comparable to dividend futures for the following reasons: 1. Between the years 2008 and 2012 (yellow section of Figure 5), implied dividends are significantly higher than dividend futures prices because implied dividends reflect cumulative dividends from the observation point to maturity, and not just those implied in the year 2012. 2. In the calendar year 2012 (blue section of Figure 5), implied dividends decrease as the year progresses; this is because the companies in the index pay out their dividends during different times during the year, and as each part of the dividend is paid out, index spot prices will change to reflect this payout, and the implied dividend for the rest of the year decreases accordingly. Hence, the 2012 implied dividends do not represent the same quantity as the dividend futures, and therefore it is not appropriate to compare the prices of the two.

Contracts Expiring Dec 2012

700 600 500 400 300 200 100 0 6/08 9/08 3/09 6/09 9/09 3/10 6/10 9/10 3/11 6/11 9/11 3/12 6/12 9/12 12/08 12/09 12/10 12/11
Temporary Convergence Market Implied Dividends include those for the years 2008- 2011 2012 Market Implied Dividends diminish as dividends are realised

Market Implied Dividend Traded Index Dividend Futures

Figure 5 Implied Dividends and Dividend Futures Prices of Eurex Eurostoxx 50 Index from 2008- 2012

However, once these cumulative implied dividends maturing in the year 2012 have been calculated, they serve to bootstrap the 2013 dividends; subtracting the cumulative dividends implied till the year 2012 from the cumulative dividends implied till the year 2013 will give us the implied dividends for 2013 alone. Therefore, we have:

The price comparisons between dividends implied by replicating portfolios and dividend futures are shown in the figures below. Figure 6 shows that when derivative futures expiring in December 2013 were initially introduced in 26 June 2008, the price closely matched that of the 2013 implied dividends. However, the price of the replication portfolio representing 2013 implied dividends fell steadily at the end of 2008, and remained below the price of the dividend futures until June 2011; the largest difference in the security prices was 97 points in June 2009. The prices of the two securities converged ~2.5 years before maturity and remained relatively close until the end of the observation period in October 2012.

200 150 100 50 0 6/08 9/08

Contracts Expiring Dec 2013

Market Implied Dividend

Traded Index Dividend Futures

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Figure 6 Pricing Analysis for Contracts Expiring December2013

The price graphs for contracts expiring in December 2014- December 2016 show similar trends. For dividend futures maturing in December 2014 and 2015, the prices of the dividend futures and corresponding implied dividends were relatively close at the launch of the dividend futures, followed 10

by a sharp decline in implied dividend prices. An anomaly is the dividend future with December 2016 maturity; December 2016 dividend futures were launched in May 2009, at a time when the 2016 implied dividends were extremely low, even taking on negative values. Nevertheless, in the months after launch, the mispricing between the securities is severe, ranging from a maximum of 100 points (2013 contracts) to 123 points (2016 contracts). The prices of the 2014 and 2015 contracts converged in December 2011 (3 years prior to maturity) and June 2012 (3.5 years prior to maturity) respectively. The prices of the contracts expiring in December 2016 have not converged as of October 2011, with the dividend futures being price ~30 points higher than the replicating portfolio.

200 150 100 50 0 6/08 6/08 -50

Contracts Expiring Dec 2014

Market Implied Dividend Traded Index Dividend Futures

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Figure 7 Pricing Analysis for Contracts Expiring December2014

150

Contracts Expiring Dec 2015

Market Implied Dividend

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0 3/09 6/09 9/09 3/10 6/10 9/10 3/11 6/11 9/11 3/12 6/12

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Figure 8 Pricing Analysis for Contracts Expiring December2015

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150 100 50 0 6/08 -50 500 400 300 200 100 0 6/10 9/10 -100 9/08 12/08 3/09 6/09 12/10

Contracts Expiring Dec 2016

Market Implied Dividend

Traded Index Dividend Futures

Figure 9 Pricing Analysis for Contracts Expiring December2016

3.2Pricing Analysis for Nikkei 225 Index (SGX)

Implied dividends on the SGX Nikkei 225 Index were calculated using the put- call replication portfolio, complete with bootstrapping to remove the effects of dividends of preceding years for 2013 to 2016 contracts. Similar to Figure 5, Figure 10 shows the cumulative dividends from observation dates ranging from 17 June 2010 (Nikkei 225 Index Dividend Futures launched) to 18 October 2012. From June 2010 to December 2011, the cumulative implied dividends are priced consistently higher than the dividend futures (yellow part of Figure 10), and then the implied dividends in 2012 begin to fall in value as the year progresses (blue part of Figure 10).

Contracts Expiring Dec 2012

Temporary Convergence Market Implied Dividends include those for the years 2008- 2011 2012 Market Implied Dividends diminish as dividends are realised

Figure 10 Implied Dividends and Dividend Futures Prices of SGX Nikkei 255 Index from 2010- 2012

Figure 11 shows the prices of the implied dividends in the year 2013 as well as the dividend futures prices; the trend seems similar to that seen in Eurex Eurostoxx 50 Index: the two securities have approximately the same price when the dividend futures are first launched, followed by a sharp 12

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decline in the implied dividends and differences in prices being up to 209 points. The prices of the two securities seem to converge in May 2012, although the implied dividends show rapid fluctuation in prices from May 2012- October 2012. However, unlike the Eurex Eurostoxx 50 Index, the SGX Nikkei 225 does not show consistent mispricing trends. Contracts expiring in 2014 and 2015 show a contrary trend; implied dividend prices are significantly higher than dividend futures from the launch of the dividend futures, and remain mostly higher than dividend futures price until convergence in June 2012 and 2012, respectively. The difference between the prices is has a similar magnitude to that seen in 2013; the maximum difference observed in 2014 is 183 points, and 135 points in 2015. Figure 14 shows that contracts expiring in December 2016 again do not follow any trends observed previously. The put and call options that make up the replication portfolio were launched in December 2011, and the implied dividends were significantly higher than the dividend future prices from December 2011- March 2012; in March 2012, the value of the replicating portfolio fell abruptly, leading implied dividends to be much lower than dividend future prices from March 2012- August 2012, and then the prices of the two securities converged in August 2012, just 8 months after the launch of the options making up the replicating portfolio.

Contracts Expiring Dec 2013

350 300 250 200 150 100 50 0 6/10 9/10 Market Implied Dividend Traded Index Dividend Futures

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Figure 11 Pricing Analysis for Contracts Expiring December2013

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Contracts Expiring Dec 2014

350 300 250 200 150 100 50 0 6/10 350 300 250 200 150 100 50 0 6/10 9/10 3/11 6/11 9/11 3/12 6/12 9/12 12/10 12/11 Traded Index Dividend Futures 9/10 12/10 3/11 6/11 9/11 12/11 3/12 6/12 9/12 Market Implied Dividend Traded Index Dividend Futures Market Implied Dividend

Figure 12 Pricing Analysis for Contracts Expiring December2014

Contracts Expiring Dec 2015

Figure 13 Pricing Analysis for Contracts Expiring December2015

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Contracts Expiring Dec 2016

300 250 200 150 100 50 0 6/10 9/10 3/11 6/11 9/11 3/12 6/12 9/12 12/10 12/11 Market Implied Dividend Traded Index Dividend Futures

Figure 14 Pricing Analysis for Contracts Expiring December2016

3.3Observations
The previous section shows that significant mispricing does exist between the dividends implied by replicating portfolios and dividend future contracts of the two indices selected. However, mispricing trends show different characteristics for the two indices studies. From the Eurex Eurostoxx 50 index, it is observed that generally, the magnitude of mispricing is highest a few months after the dividend future is first launched, with the implied dividends being severely underpriced as compared to the dividend futures. As the contracts approaches maturity, prices of the two securities converge ~2.5-3.5 years before maturity, with the implied dividend eventually out- valuing the futures in some cases. Another trend observed is that the prices of the two securities converge earlier as the maturity date increases; the prices of the two securities for the 2013 contracts converge 2.5 years prior to maturity, where those maturing in 2014 and 2015 converge 3 and 3.5 years prior to maturity respectively. One possible explanation for this is that as investors become more accustomed to trading dividend futures, markets become more efficient and information is assimilated faster to wipe out mispricing at increasingly earlier dates. Unlike the Eurex Eurostoxx 50 Index, the SGX Nikkei 225 Index does not sow systematic mispricing with respect to time. Pricing mismatches of both kinds are observed: implied dividend can be both higher and lower in price than their corresponding dividend futures. This is contrary to the Eurex Eurostoxx 50 Index, where dividend futures prices are generally seen to be higher than implied dividends before convergence. Furthermore, the prices of the two securities converge faster, even though dividend futures are newer to SGX than Eurex; this suggests that perhaps local investors are more meticulous about pricing their derivatives according to marker information, making the market more efficient. 15

3.4Implications
In this section we study the scenarios in which mispricing between dividend futures and implied dividends gives rise to two important investment scenarios: arbitrage and low risk investment opportunities. We will be using the Eurex Eurostoxx 50 Index data to investigate arbitrage and lowrisk investment opportunities, as it shows more significant and consistent mispricing than the SGX Nikkei 225 Index. Arbitrage is a scenario in which mispricing between securities enables investors to buy and sell securities in a way that enables them to make a risk- less profit. Arbitrage represents market inefficiency and in the real world, traders usually move quickly to exploit arbitrage opportunities until market prices correct themselves. In this section we will study the different ways in which stocks, call and put options and dividend futures with different maturities can be traded so as to obtain a risk- free or low risk profit for investors. Let us assume that we are now in year 1, and we long a replicating portfolio of implied dividends expiring in the year T. In this scenario, what we are buying is the cumulative sum of dividends from year 1 till year T:

In this case we, we pay a premium for the cumulative implied dividends, and are long the index (and hence entitled to all realized dividends), short a call and put option expiring in the year T, struck at the strike price K, and short $K in cash. We can offset this net cash outflow in two ways: first by shorting dividend futures, and second, by receiving realized dividends. What is required for profit is:

The next two sections details how both arbitrage and low- risk profit can be exploited from the situation by employing different combinations of realized dividends and dividend futures.

3.4.1 Arbitrage Opportunities

For arbitrage to be possible a profit must be made independent of the uncertainties (risks); hence, the following condition must be satisfied:

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This means that either all risk associated with realized dividends is removed, or even if all dividends before the maturity year are cancelled, the investor is able to make a profit. This is achievable in three ways: 1. We hedge the uncertainty associated with realized dividends by selling dividend futures for each year from years 1 to T; in this way, all dividends realized from years 1 to T will be credited to the dividend futures buyer. In scenarios where the sum of cash received from selling dividend futures exceeds the premium paid for implied dividends, the investor can make an immediate and risk- free profit. For example, if we take a look at the market situation on 29 December 2008 (a date picked so as to avoid the complication of partial- dividends), we see that: Price of replicating portfolio of Implied Dividends from 2009 to 2013: 337.77 points Price of dividend futures:
Table 1 Eurostoxx 50 Dividend Futures prices on 29 December 2008

Expiry Year 2009 2010 2011 2012 2013

Price 100.4 69.5 68.3 69.3 71.8

In this case, Risk free profit= 337.77- [100.4 + 69.5 + 68.3 + 69.3 + 71.8]= 41.53 points Therefore, investors can eliminate all dividend risk for years 2009- 2013 by selling dividend futures for these years; effectively the investor would be transferring all dividends received from the index to the dividend futures buyers, and not be exposed to the negative implications of low dividend payouts themselves. Hence, by monitoring the market for instances where the cost of buying implied dividends is lower than the sum received by selling dividend futures for each year till expiry, investors may make a modest, risk- free profit. The example shown here is a trade done at the end of the year, hence removing the risk associate with 2008 dividends. In reality, trades carried out in the beginning/ middle of calendar years have risk in the form of realized dividends to be received in the same calendar year. However, these risks may be considered low, almost negligible, by many investors. 2. Investment is carried out in the year T, and the price of the replicating portfolio that represents implied dividends is lower than the price of the dividend futures expiring in the same year. i.e. in the year 2013, the prices of Implied Dividends expiring in December 2013 is lower than the price of dividend futures maturing in December 2013. This scenario removes the uncertainly of the dividend payouts from years 1 to T-1. 17

From the data seen in the previous section, we see that prices of implied dividends and dividend futures expiring concurrently converge 2.5 3.5 years before maturity and such arbitrage opportunities are not observed in existing market data.

3. In year 1, the price of the replicating portfolio that represents implied dividends from years 1 to T is lower than the price of the dividend futures expiring in the year T. i.e. in the year 2008, the prices of implied dividends from 2008 to 2013 is lower than the price of dividend futures maturing in December 2013. This scenario ensures a profit for the investor at the time of the transaction, and this profit will be maintained regardless of future dividend payouts; the instant profit is the minimum profit that will be earned by the investor, even in the unlikely case that all dividends henceforth are cancelled; furthermore, any future dividend payouts will lead to further profit. The graphs below show the prices of cumulative implied dividends and dividend futures at different observation times:

Figure 15 Arbitrage Opportunities

Figure 15 shows that arbitrage opportunities were observed in June 2009 for contracts expiring in December 2015 and 2016 (circled in orange). However, it can be seen that these are fleeting opportunities, arising from momentary market inefficiencies rather than from systematic mispricing. The markets move swiftly to eliminate these instances of mispricing and hence, arbitrage opportunities are only available to vigilant investors and do not represent the general market state for these securities.

Therefore, from our study of market conditions, we see that scenarios do exist in which investors can take advantage of mispricing to realize risk-free profits. However, as is characteristic of arbitrage 18

opportunities, these are apparently only to careful and vigilant investors and may only exist for limited periods of time and have limited profit. The next section addresses cases for low- risk profit, which are much more prevalent and have a much higher potential for returns. 3.4.2 Low Risk Investment Opportunities

Despite limited conditions for arbitrage, opportunities for low risk profit are present. Revisiting the condition necessary for a profit, we see that:

In Section 3.4.1, we hedged the risk associated with realized dividends for years 1 to T-1 by selling dividend futures for these years. However, investors who are comfortable with taking a higher level of risk can potentially increase their returns by not using these hedges. By studying past patterns of dividend payouts, we can assess the risk associated with realized dividend payouts from years 1 to T1, and as an investor, decide is such a risk- return trade-off is agreeable to us. Revisiting our previous example, we see that the following dividends were realized in the years 2009 to 2012:
Table 2 Realized Eurostoxx 50 dividends in the years 2009- 2012

Year 2009 2010 2011 2012 (as of 1 Nov 2012)

Realized Dividend 115.71 112.75 124.34 111.33

Therefore, for profit, we need:

From market-observed realized dividends, we see that

Hence, the investor would already have made a profit of 464.12- 265.97= 198.15 points by Nov 1 2012, subject to increase based on the dividends paid out in November and December 2012. This is significantly higher than the risk-free profit of 41.53 points. In fact, to break even, the investor only 19

needs an average realized dividend of significantly lower than realized dividends in recent years.

points every year, which is seen to be

Therefore substantial profit is possible, but at a certain level of risk. It may be worthwhile for investors to assess how substantial dividend risk is. Figure 16 shows that dividend payouts have been above 100 points from 2005- 2012; savvy investors could estimate the expected realized dividends for future years, as well as the downside risks in cases of unprecedented low dividend payouts. As dividend risk is generally not high, many investors may be comfortable with not hedging realized dividends for the years before maturity, and hence dramatically improving their returns.

Figure 16 Realized Eurostoxx 50 Index Dividend Payouts from 2005- 2012

In this section we have shown that significant mispricing exists between dividends implied by replicating portfolios of the Eurex Eurostoxx 50 and SGX Nikkei 225 indices and put and call options, and the dividend futures for the same indices. It can also be seen that mispricing is more significant and systematic for the Eurex Eurostoxx 50 Index Dividend Futures than the SGX Nikkei 225 Index Dividend Futures. Furthermore, we have conducted an analysis into the potential for arbitrage and low-risk profit for investors arising from mispricing. We find that arbitrage is possible in two ways: 1. Buying a replicating portfolio and selling dividend futures for each of the years between the year of transaction mad maturity of the put and call options; arbitrage is possible is the sum of the prices of the dividend futures is less than the price of the replicating portfolio. This is equivalent to hedging all realized dividends by selling dividend futures. 2. Buying a replicating portfolio and selling a dividend future for a single year, in the case when the price of the single dividend future is greater than that of the replicating portfolio However, as is characteristic of arbitrage scenarios, these conditions are observed only in limited time period, and may give a modest profit, at best.

For investors with greater risk appetites, more prevalent conditions for low-risk, high- return investment strategies exist in the form of buying replicating portfolios of implied dividends, and selling single dividend futures contracts, while leaving the implied dividends for preceding years 20

unhedged. This enables investors to profit from realized dividends, but leaves them exposed to the risks as well. As dividend risk has historically been low unprofitable scenarios are unlikely and this strategy may provide a viable and rewarding investment opportunity.

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Chapter 4 Conclusions
This project has focused on studying the fair pricing and investment opportunities related to index dividend futures, an increasingly popular derivative. The first part of this project assesses the fair price of dividend futures contracts through comparison with a replication portfolio of implied dividends using the put- call parity of index options. This is similar to future work done by Wilkens and Wimschulte and Barakat and Coscas in 2009; however this project expands and improves on these studies in three important ways. First, we expand the time- scope of the studies by analysing data for the Eurex Eurostoxx 50 Index from June 2008 till October 2012, as well as diversifying the study to include SGX Nikkei 225 Dividend futures to assess whether trends in pricing hold across different markets. Second, we identify an important methodological oversight in the first two pieces of work, and improve upon this. Last, we study the implications of mispricing in the form of its contribution to arbitrage and low-risk investment opportunities. As seen in previous studies, we find that significant mispricing exists in both the Eurex Eurostoxx 50 Index and, to a lesser extent, in the SGX Nikkei 225 Index. Mispricing in the Eurex Eurostoxx 50 Index is systematic and shows the implied dividend being significantly under- valued as compared to the dividend futures up to ~3.5 years prior to maturity. The SGX Nikkei 225 Index shows mispricing in which the implied dividend may be both over and under- valued as compared to the dividend futures, depending on the maturity of the securities or the time between the observation date and maturity date; hence the mispricing does not follow any systematic trend. Furthermore, the prices of the SGX Nikkei 225 Index securities converge much earlier than those of the Eurex Eurostoxx 50 Index; however, the Eurex Eurostoxx 50 Index security prices are also seen to be converging earlier as the maturity date increases, demonstrating that the market is becoming increasingly efficient. We also determined that mispricing between dividends implied by replicating portfolios and dividend futures opens up avenues for arbitrage and low- risk investment. Arbitrage was observed in two different ways: 1. When an investor longs a replicating portfolio of implied dividends and hedges all realized dividends by shorting dividend futures; in cases where the cash received from shorting dividend futures is higher than the premium paid for buying implied dividends, risk- free profit can be made. 2. When an investor is able to buy a replicating portfolio of implied dividends for less than the cash received from shorting a single dividend future. Both cases represent short- lived market conditions, and market prices would like move to remove these instances of arbitrage. However, much more prevalent are conditions for low- risk arbitrage. This occurs when an investor longs a replicating portfolio of implied dividends and shorts a single dividend future, but does not hedge intermediate dividends. As implied dividends have recently been seen to be undervalued, the realized dividends could lead to a significant profit to the investor. This of course, comes with the risk of very low dividend payouts, but historically dividend risk has been low and this is a promising avenue for investment.

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The analysis carried out in this project indicates that the prices of dividends in the market are not always efficient and therefore dividend futures, when used in conjunction with the underlying index and options can be profitable to investors at relatively low risk. Until a combination of scholarly articles and market efficiency inevitably eradicate derivative mispricing, investment opportunities are ripe for strategic and innovative investors. Hence, as dividend futures become proliferate and thrive in markets around the world, savvy investors should take note of this promising new derivative.

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Chapter 5 References

1. Sascha Wilkens and Jens Wimschulte. February 2009. The pricing of dividend futures in the European market: A first empirical analysis. Working paper, submitted for publication. London/Cologne. 2. Habib Barakat and Jeremie Coscas. Listed dividend swaps on Eurex: Does mispricing mean arbitrage opportunities? Final year thesis, HEC Paris, 2009.

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