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Stochastic Proportional Dividends
Stochastic Proportional Dividends
Stochastic Proportional Dividends
Working Paper
J.P. Morgan∗
Equity Derivatives Group
Quantitative Research
London
First draft: January 2010 - This draft: March 2011,
Revision 1.02
Abstract
Motivated by recently increased interest in trading derivatives on div-
idends, we present a simple, yet efficient equity stock price model with
discrete stochastic proportional dividends. The model has a closed form
for European option pricing and can therefore be calibrated efficiently to
vanilla options on the equity. It can also be simulated efficiently with
Monte-Carlo and has fast analytics to aid the pricing of derivatives on
dividends. While its efficiency makes the model very appealing, it has the
twin drawbacks that dividends in this model can become negative, and
that it does not price in any skew on either dividends or the stock price.
We present the model and also discuss various extensions to stochastic
interest rates, local volatility and jumps.
1 Introduction
The recent years have seen an increased interest in trading more directly one
of the most basic features of equity stock prices, its dividends. Dividends are
comparable to coupons of a bond since they provide the equity holder with a
stream of income. The main difference, of course, is that a company can decide
how much dividend it will pay, hence the dividend amounts are a function of
the company’s performance.
∗ Opinions expressed in this paper are those of the authors, and do not necessarily reflect
The culmination of this process so far was the introduction on May 25, 2010
of options on the “S&P500 Annual Dividend Index (DIVD)” and the “S&P 500
Dividend Index (DVS)” on the CBOE [12], and the introduction on the same day
of options on both “Euro STOXX50 Index Dividend Futures (FEXD)” and the
“Euro STOXX50 Index Dividend Points (DVP)” on Eurex [2]. The exchange
traded contracts have the potential to improve price discovery for the volatility
market on dividends substantially.
Aside from the listed market, there also the market of OTC derivatives.
Here, the potential for structuring ideas around dividends are wide: options on
dividends are one way to expresss a view on dividends, but other products such
as Dividend Yield Swaps and Knock-Out Dividend Swaps can give a much more
tailored exposure to the realized dividends of an index or a given equity.
In addition, there is also a natural interest in products which give exposure
to the “yield gap” between the yield on bond investments and the yield derived
from dividends.
This article is structured as follows: first, we will introduce our setup and
a set of interesting payoffs. We then present our main model and discuss its
properties as well as a calibration procedure which we apply to market data
for STOXX50E. In the next section we show how an efficient Monte-Carlo
scheme can be implemented and how we can compute dividend future prices
on the given Monte-Carlo paths. We also compute some sample option prices.
A final section discusses extensions of the model to stochastic interest rates,
credit and jump risk, and local volatility (with numerical methods). The sec-
tion concludes with a comment on the connection to Gaspar’s HJM-framework
for the forward curve.
An appendix contains most of the actual calculations.
Acknowledgements
We are very grateful for the help of Christopher Jordinson, now at UBS, many
of whose ideas are incorporated in the model we present here. His input was
crucial to the development of the model.
1 For a thorough review of this setting, cf. Bermudez et al. [3] and, in more detail,
Buehler [6].
Dividend Derivatives
A dividend swap on the equity between the dates T1 and T2 pays the accumu-
lated dividends between these two dates against a fixed strike K, i.e.
X
∆i − K .
i:T1 ≤τi ≤T2
where we used the notation x+ := max(0, x). Note that dividend futures usually
pay the realized dividends of the respective underlying index. Hence, an “option
on a dividend future” is effectively also an option on realized dividends for the
period of the future.
More advanced OTC products on dividends are structures, where the payoff
of the dividend is linked to the performance of the equity itself. One example is
a knock-out dividend swap, i.e. a dividend swap which knocks out if the equity S
trades below a given barrier. The payoff for this product is
X
1 mint:T1 <t≤T2 St <B ∆i − K . (1)
i:T1 ≤τi ≤T2
2 We do not model the possibility of default here, but an extension to the case of a deter-
ministic hazard rate model is well within our framework, c.f. the discussion in [6].
3 For ease of exposure we assume that the payment dates are equal to the ex-div dates. An
where (ti )i are monthly fixings (other variants scale the realized dividends by
the stock price at the end of the period, or divide each dividend by the stock
price of the previous trading day).
As mentioned before, there is a recent interest in rates-dividend hybrid prod-
ucts, for example those which allow to manage an exposure to the difference in
dividend and bond yields. Figure 2 shows that the implied yield on equity is
recently higher than the yield which can be derived from investing in bonds.
A good example of a product which allows to hedge this “yield gap” would be a
Figure 2: Dividend yield is high in both absolute and relative terms compared to
bond yields.
“Leveraged Div Yield Swap Certificate” which basically pays coupons which are
a difference between interest rates and dividends: We simplify the product for
the sake of simplicity. The simple version works as follows: define the realized
dividend yield between two times T1 and T2 as
1 X
ryld(T1 , T2 ) := ∆i
ST2
i:T1 <ti ≤T2
and let CMSt (1Y ) denote the 1Y libor rate observed at time t. Then, the
product pays
!
X n o
max 100% + 5 CMSt (1y) − ryld(t, t + 1y) , floor
t=1y,2y,3
where the floor is, for example, 30%. In this form, the product provides a
positive exposure to a drop in dividend yield vs. interest rates.
∆it := Et ∆i .
(3)
∆i0
i −Di i
∆ = Sτi − (1 − e ) with D := − ln 1 − . (4)
Fτi −
5 This follows since both Fτi − e−Di = Fτi and Fτi − − ∆i = Fτi have to hold.
St = Ft Xt ,
(we use δx (·) to denote the Dirac-measure in x). In this model, the dividend
stream is obviously stochastic – it exhibits the same volatility as the underlying
equity.
but the dividend ratios di are random: to model them, we use an Ornstein-
Uhlenbeck process
dyt = −κyt dt + ν dBt
and set
di := (Di + Ei yτi ) + Ci (7)
where Di is the Black & Scholes value for the proportional dividend as defined
in (4). The constant Ei allows to blend between normal and log-normal volatility
for the dividend yield by using Ei ≡ 1 or Ei ≡ Di , respectively. Finally, the
constant Ci is determined by matching the forward such that E[St ] = Ft for
all t using an analytical procedure; see appendix A.2 for details.
Remark 2.1 Our model can easily be extended to incorporate a fixed cash-
dividend part for each dividend. For example, we could assume that a fraction αi
of each dividend ∆i is fixed in cash. Compared to (4), the stochastic dividend
in such a model becomes
for a suitable D̃i which ensures that the forward of the process is correct. Ap-
pendix A.1 provides some more details.
To motivate our model choice, let us define the “forward yield” between T1
and T2 , seen at a time t, as the sum of the expected dividends between the two
reference times, divided by the current spot level:
i
P
i:T1 <τi ≤T2 ∆t
ȳt (T1 , T2 ) := .
St
Figure 3: The graph shows historical log-dividend yields for future periods. For
example, the 9Y/10Y point refers to the floating maturity forward dividend swap
between 9Y and 10Y, divided by the spot at the observation point.
Model Properties
The first important observation is that the model’s stock price is log-normal:
its explicit form is
R τi −κ(τ −s)
{Ci +Di +Ei [y0 e−κτi +ν
Rt
σ dWs − 12 0tσs2 ds− i:τ dBs ]}
R P
i
0 s 0 e
St = Rt S0 e i ≤t ,
then the respective implied volatility is calculated from observed market prices.
7 The very negative correlation is not only necessary to be able to provide a decent fit to
the observed market prices; it is also economically sensible as we will explain below.
Negative Dividends
While most of the properties of our model are appealing, the model’s structure
also reveals its main drawback: the fact that the dividends themselves can
become negative. This happens if di becomes negative. The probability of this
happens at a dividend date τi is
" r #
1 − e−2κτi Di + Ci −κτi
P Yν ≤ − y0 e
2κ Ei
10
where Y is standard normal. For the calibrated model above, the annual prob-
ability of having negative dividends is around 1% in the model as is shown
in figure 8. The same figure also shows that the size of the negative dividends
in relation to the total forward is (predictably) small.
However, we think that the advantage of analytical tractability of the model
far outweighs the downside of having potentially negative dividends.
In order to simulate the model (6), we assume that we have some “observa-
tion dates” 0 < t1 < · · · < tn of interest at which points we wish to evaluate
our payoff; for ease of exposure we assume w.l.g. that these dates include all
dividend dates in the respective period.
A convenient feature of our essentially normal model is that we do not need
to use Euler to simulate our SDE because the model is in fact normal between
two of the observation dates. Assuming constant equity vol of σk between tk−1
−2κdtk
and tk = dtk + tk−1 , the variance of the increment dy is Σyk = ν 2 1−e 2κ , the
variance for the equity increment is ΣSk := σk2 dtk and the covariance between
11
Figure 7: Visual comparison of a negative correlation case above visually with historic
data.
−κdtk
the two is ρνσk 1−e κ , which means that the correlation is
1 − e−κdtk
ρk := ρ √ q .
1 − e−2κdtk 12 κdtk
Hence, if we chose a iid sequence of standard normal random variables (Yk , Ŷk )k ,
we can simulate on big step between tk−1 and tk using
q q
−κdtk y 2
ytk = ytk−1 e + Σk ρk Yk + 1 − ρk Ŷk
p 1 Fk
log Stk = log Stk−1 + σk dtk Yk − σk2 dtk + log − (Ek ytk + Ck ) .
2 Ftk−1
(We used a slightly lax notation here: the Dk , Ek and Ck are either the relevant
coefficients from a dividend payable at tk or zero.)
Another strength of the model is that it is possible to efficiently calculate
12
the forward price of the equity as a function of spot and the driving Ornstein-
Uhlenbeck process u at a given future time efficiently since it has the form
RT At (T )yt +Bt (T )
Ft (T ) := Et [ ST ] = St e
Rt
for some deterministic functions A and B (see appendix A.3 below). This is
important because it allows us8 computing future expected dividend values on
a given Monte-Carlo path efficiently using
Rτ`
∆`t = Ft (τ`− ) − Ft (τ` ) = Ft (t ∨ τ`−1 ) − Ft (τ` )
Rt∨τ` −1
(x ∨ y := max(x, y)). Hence, the model permits efficient access to pricing divi-
dend swaps analytically within a Monte-Carlo simulation. This means we can
use the model to price and risk manage not only options on realized dividends,
but also on more involved trades which depend in value on futures on dividends.
As an example, figure 9 shows a sample path of both stock price and a div-
idend future generated by the model.
13
Another interesting product is the Dividend Yield Swap (2). It pays the sum
of realized dividends over the monthly spot price average.
Our model gives us:
Dec10-11 Dec11-12 Dec12-13 Dec13-14
4.13% 4.09% 3.97% 3.97%
14
(in practical applications, one would never actually calculate θ but use it only
in integrated form; see [3]). Given our Hull & White model, we can now define
the equity process via, once again,
dSt X
= (rt − µt ) dt + σt dWt − (1 − e−di ) δτi (dt)
St i
with di given again as in (7) with adjusted C’s. Since r and therefore any
integral over it are normal, it follows that the stock price process in this joint
Hybrid model is still log-normal. Consequently, the analytic tractability of the
model is preserved and it is a very convenient candidate if we want to price
joint rates-dividend derivatives. We even maintain the ability to run an efficient
Monte-Carlo by using the methods discussed in Brockhaus et.al. [5], page 36.
Remark 3.1 Both our original and our rates/dividends hybrid model allow the
introduction of several Ornstein-Uhlenbeck factors to drive the respective curves;
see also Hull’s description for the 2-factor rates model in [8].
15
This model has the desired properties of synchronous crashes in equity and yields
while it maintains enough flexibility to be adapted to “small” jumps which do
not affect the yield itself (they will affect the dividends being proportional to
the spot price level). Note that one drawback of incorporating negative jumps
into u is that the proportional dividend factors di are more likely to become
negative.
In terms of analytical tractability this model is once again very convenient:
conditional on the number of jumps for each Poisson-process this model has a
log-normal distribution which means
that it can be used efficiently using Fourier-based pricing for European op-
tions.
The local volatility function itself can then be calibrated using forward-PDE
methods such as the one described in [3] for the calibration of a local volatility
function on top of a stochastic rates equity pricing model.
where the Di are the proportional dividends from the Black & Scholes formu-
lation (5), and where the continuous function C̄ is chosen such that the model
16
4 Conclusions
We have discussed a stochastic dividend model with very tractable analytics for
calibration towards the vanilla market and for the pricing and risk management
of dividend derivatives. To the best of our knowledge, this is the first attempt to
model the dividend stream of an equity in a consistent manner for the purpose
of derivatives pricing. The model’s simplicity qualifies it as a standard tool in
a derivatives library, while the fact that its dividend are not always positive
and that it does not capture the implied volatility skew in either equity or
dividends means that there is clearly a further need for development in the
dividend modeling area.
5 Disclaimer
Opinions and estimates constitute our judgement as of the date of this Material,
are for informational purposes only and are subject to change without notice.
This Material is not the product of J.P. Morgan’s Research Department and
therefore, has not been prepared in accordance with legal requirements to pro-
mote the independence of research, including but not limited to, the prohibition
on the dealing ahead of the dissemination of investment research. This Material
is not intended as research, a recommendation, advice, offer or solicitation for
the purchase or sale of any financial product or service, or to be used in any way
for evaluating the merits of participating in any transaction. It is not a research
report and is not intended as such. Past performance is not indicative of future
results. Please consult your own advisors regarding legal, tax, accounting or
any other aspects including suitability implications for your particular circum-
stances. J.P. Morgan disclaims any responsibility or liability whatsoever for the
quality, accuracy or completeness of the information herein, and for any reliance
on, or use of this material in any way.
Important disclosures at: www.jpmorgan.com/disclosures
Rt h Rt 1 Rt 2 Rt i
10 I.e. we use the relation e0C̄s ds = E e 0σs dWs − 2 0σs ds− 0ys ds to find C̄.
17
(1 − αi ) ∆i0
D̃i := − ln 1 − .
F̃τi −
dS̃t X
˜(1e − e−di ) δτ (dt) .
= (rt − µt ) dt + σt dWt − i
S̃t i
and will, with appropriately calculated C̃i , reprice the forward. The calculations
for C̃ are the equivalent to the one for the model discussed in the text.
18
with R t −κ(t−s)
Θ(t, u) := ue
θs ds
K(t, u) := e−κ(t−u)
−2κ(t−u)
Γ(t, u) := 12 ν 2 1 − e 2κ
.
We also abbreviate
Iteration
The aim is to make sure with out choice of (Cj )j=1,...,N that
h P i
!
EQ e− j:j≤` dj h P i
Q − j:j≤` (Ej yτj +Cj )
1= P = E e .
e− j:j≤` Dj
Consider the formula
h P i
c` (p) := log EQ e− j:j<` (Ej yτj +Cj )−(E` +p)yτ`
which obviously yields with C` := c` (0) the desired correction terms. We will
derive these functions iteratively: we start with ` = 1. Using (10) yields readily
The next step is ` > 1 to determine c` (p) assuming we know cj (q) and there-
fore Cj for j < `.
h P i
ec` (p) = EQ e− j:j<` (Ej yτj +Cj )−(E` +p)yτ`
h P h ii
= EQ e− j:j<` (Ej yτj +Cj ) EQτ`−1 e
−(E` +p)yτ`
h P 2
i
= EQ e− j:j<` (Ej yτj +Cj ) e−(E` +p)K` yτ`−1 −(E` +p)Θ` +(E` +p) Γ`
h P i 2
= EQ e− j:j<`−1 (Ej yτj +Cj )−(E`−1 +(E` +p)K` )yτ`−1 e−(E` +p)Θ` +(E` +p) Γ` −C`−1
2
= e−(E` +p)Θ` +(E` +p) Γ` +c`−1 ((E` +p)K` )−C`−1
19
c` (p) = −(E` + p)Θ` + (E` + p)2 Γ` + c`−1 ((E` + p)K` ) − C`−1 (11)
is well-defined.
and all further terms have the same structure as (11), i.e.
20
References
[1] B.Baldwin:
The World of Equity Derivatives - The Essential Toolbox for Investores,
Eurex, September 2008,
http://www.eurexchange.com/download/documents/publications/
TheWorldofEquityDerivatives.pdf
[2] B.Baldwin:
“Dividend Derivatives: Introduction of Options on EURO STOXX50 Index
Dividend Futures”, eurex circular 082/10, May 2010,
hhttp://www.eurexchange.com/download/documents/circulars/cf0822010e.pdf
21
[12] D.Wood:
“Options on DIVD and DVS Indexes”, CBOE Website, May 2010,
http://www.cboe.com/micro/dvs/introduction.aspx and
http://www.cboe.com/micro/dvs/DIVDFAQ.pdf
22