index dividend futures: pricing strategy and investment analysis

FE 5110

Financial Engineering Project

Index Dividend Futures:

Pricing Strategy

and Investment Analysis

Priyanka Bhandari

A0069105J

2

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

3

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.

4

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.

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.

Figure 2 Eurostoxx Dividend Futures Prices

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Eurostoxx Dividend Futures Contracts DEDZ2 (Expiring Dec 2012)

DEDZ3 (Expiring Dec 2013) DEDZ4 (Expiring Dec 2014)

DEDZ5 (Expiring Dec 2015) DEDZ6 (Expiring Dec 2016)

Buyer Seller Fixed Amount

Realized Dividends

on Stock(s) or Index

Figure 1 Dividend Swap

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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 ever-

increasing volumes.

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

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

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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.

7

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 index’s 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:

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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.

9

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.

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

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Market Implied Dividend

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Market Implied

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However, once these cumulative implied dividends maturing in the year 2012 have been calculated,

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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.

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

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Contracts Expiring Dec 2013 Market Implied Dividend


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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.



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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).

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

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2012 Market Implied

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Temporary

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13

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.


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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.

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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 low-

risk 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 Price

2009 100.4

2010 69.5

2011 68.3

2012 69.3

2013 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.

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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

19

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 T-

1, 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 Realized Dividend

2009 115.71

2010 112.75

2011 124.34

2012 (as of 1 Nov 2012) 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

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needs an average realized dividend of

points every year, which is seen to be

significantly lower than realized dividends in recent years.

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

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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 undervalued 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 undervalued 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.

index dividend futures: pricing strategy and investment analysis

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