Eurex
With dividends now firmly recognized as a standalone asset class, its listed derivatives market has continued to grow with the recent launch of Mid-Curve Options. The ecosystem of products that began with dividend futures is constantly evolving with an expanding variety of strategies, enabling market participants to position more precisely.
“Dividends are undeniably an asset class on their own," says Arthur Villard Sichel, head of thematic indices structured products and dividend options trading Europe at Goldman Sachs.
“The dividend curve tends to be downward sloping, with structured products flow putting pressure on the curve. This means dividends tend to trade quite below their market estimate. Coupled with the fact that dividends reduce multiple/rate risk, it means that many end users find dividends and their derivatives to be a great alternative to just being long equity.”
The latest step in the market’s evolution was the 5 February launch of Mid-Curve Options on EURO STOXX 50® index dividend futures.
As with the original dividend futures, Mid-Curve Options created an exchange-traded alternative to an established OTC market.
In this case, Eurex has given market participants a listed product that mirrors functions of the swaptions market, in which about $3bn was traded last year. Here, fewer market-makers are quoting off-screen and some only show bids. This has made it hard for end-users to obtain tight two-way pricing for buying swaptions.
“Previous OTC-to-listed migrations have had very positive effects, such as the total return future, when repo trading exploded in liquidity post-listing,” says Villard Sichel. “It will be exciting to see if liquidity in short-dated dividend volatility also picks up following the Mid-Curve Options launch.”
Mid-Curve Options expire on an underlying future with a longer expiry date than the next settling future. The options focus on the next five years of dividends, allowing participants to fine-tune risk management or anticipate changes in dividend expectations.
Mid-Curve Options allow users to manage short-dated dividend risk and convex risk on long-dated dividends. They expire on an underlying future with a longer expiry date than the next settling future.
The product expands the use cases for dividend derivatives. For banks, they offer a hedge on short-term volatility risk, which is a feature of the structured products they issue. They also serve as a hedge for macro conditions.
Short-end volatility
The product’s launch comes at an interesting time for the dividend market. Since 2020, there has been much more volatility in short-dated dividends, previously a relatively stable part of the curve.
“Market dynamics have changed, bringing more volatility at the short end of the curve than the long end,” says Yanis Escudero, Head of Delta One Flow Trading Europe at BNP Paribas.
“Exotics desks are much less short gamma on dividends in the longer-dated part of the curve than they used to be. Some product issuances even made them long gamma, pushing dividends higher amid weaker overall market conditions, while decrement indices have gained market share.”
“On the other hand, short-dated dividend positions have seen the opposite effect. Dealers have been short gamma due to selling upside calls on DEDZ (Deka-Nachhaltigkeit Aktien Europa) and DBEZ (Xtrackers MSCI Eurozone Hedged Eqty ETF), putting additional pressure and volatility on short-dated dividends.”
“Last year we saw longer maturities strongly outperforming the spot on the back of smaller exotic supply and the rates trajectory. Consequently, forward yields have drifted higher all year, with the SX7E (EURO STOXX® Banks index) leading the group. Dec26 & Dec27 Forward yields on 7E have reached historical highs, standing respectively at 6.90% & 6.10%.”
Decrement indices, which strip out dividend risk, exert an increasing influence on the market, counterbalancing some of the selling pressure that structured products can create in market downturns.
“Looking at the discount to the front of the curve, the market is pricing a couple of percent more risk premia compared to the average over the last ten years,” says Villard Sichel.
“Structured products issuance has been undeniably large, but it is worth noting that a decent proportion of the classic SX5E (EURO STOXX 50® index) business is switching to thematic indices where the dividend is fixed, hence removing dividend risk from dealers’ books. We see this as a potential catalyst for dividend risk premia to reduce (both in the delta one and volatility space).”
From a fundamental perspective, the dividend market looks set to build on its success from 2023, when expectations of a strong year were met.
“In 2023, we experienced large earnings and upside revisions driven by higher margins and resilient volumes,” says Escudero. “Many investors have been deploying capital to take exposure to short-term dividends in a strong short-term earnings market environment where there are still uncertainties. Despite some scepticism, 2024 is heading towards being another year of earnings upgrade, especially on cyclical names.”
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