Client demand is driving dealers to look at ways of pricing options on stock dividends. Dealers have built up exposure to dividends through selling equity forwards and in the last few years have sold this exposure in swap form on to hedge funds at a discount. But the funds, now sitting on substantial gains from the swaps, want to purchase downside protection. And dealers have also started to see that being able to sell dividend exposure in option form would be more attractive to a wider range of clients--for a start, it could be packaged up as a bond for real money managers.
Firms including Barclays Capital, Citigroup, Goldman Sachs and Deutsche Bank are looking at hedging and pricing the options. Goldman is driving the activity, and is already showing prices for the instruments.
Equity salesmen at several houses said they have fielded inquiries from hedge funds in the last few weeks and one equity strategist said his firm had also discussed wrapping a dividend option in a medium-term note for an institutional client. "Demand is key," noted a hedge fund salesman at a French firm. The salesman said his firm had looked at offering options on dividends a few years ago, but had not had much client interest in the idea. This time round, hedge funds' demands are driving the buzz on the Street.
Traders noted, however, although there's a lot of talk they have not yet seen anything traded. One official noted dealers may be holding back to gauge the scale of demand before offering the instruments, because of hedging concerns. While hedging an option on a dividend swap is possible because of the increasing liquidity of the swaps, pricing options on realized dividends is harder because dividends are ultimately the result of a corporate decision, rather than a technical factor that can be modeled.
The likelihood is if demand is high enough, dealers will simply carry the risk. Selling options could help dealers lay off their dividends exposure with a wider range of clients. Institutional fund managers are put off dividend swaps because when the realized dividend is very low, that could mean a negative flow from them in the swap, explained one salesman. But fund managers could purchase call options on the dividends which would mean paying only the initial premium. This could be particularly attractive in a capital-protected note form, he added.
