One of my favorite advertising slogans from childhood was the Wendy’s “where’s the beef?” question regarding competitor (i.e., McDonalds and Burger King) hamburgers.
I often hear a similar question regarding structured notes – “where’s the dividend?” A key difference between structured note investments and more traditional securities is the lack of a dividend in most structured notes. For example, a note linked to SPY (the S&P 500 ETF) will not necessarily pay out any yield or dividend despite the fact that SPY itself does pay out a dividend. This disparity results in an assumption by some investors that the issuers “pocket” the missing dividend and thereby deprive investors. This is simply not true – the dividend, or lack thereof, is taken into account when creating and pricing a structured note. Today we will explore just how the reference security’s dividend does get utilized in the pricing of a structured note as well as in OTC and listed options.
Why are we interested?
There are many things that issuers of structured notes can do better, and I believe investor advocates and the media have been correct in pointing out those flaws. However, one area in which structured note issuers have been unfairly criticized is the missing dividend. Over the years, I have heard many structured note users express the belief that structured note issuers were pocketing the dividend of the underlying. This reflects a misunderstanding of what a structured note actually is.
Since a structured note references an underlying security or index, one might think that the issuer would receive any dividend paid on the underlier (and should pass it on to the investor.) However, this is not the case. The composition of a structured note does not typically include the referenced security itself, but rather options on the referenced security. Options do not pay out dividends; thus, any dividend paid out on an underlying security does not accrue to the option holder. The reason the issuer uses options on the reference securities instead of the referenced securities themselves is because options enable an issuer to perfectly hedge the risk associated with a structured note. If issuers use referenced securities in place of options, they can only hedge out a limited amount of the risk associated with the position (i.e. delta hedging, not a complete hedge).
An exception is when a “special dividend” is paid. In this case, the option will receive the benefit through an adjustment of the strike or ultimate option payout, but not an actual payment at the time of the dividend. A “special dividend” is generally defined as a one-time dividend payout worth 10% or more of the value of the stock. As regards to structured notes, in instances where there is a special dividend on a security utilized in a structured note, the note issuer will generally follow the rules governed by the listed market for options, and thus note investors will participate in any special dividends.
Bottom line, no dividend should be due the holder of a structured note when the note is constructed with options on the reference security or index, which is the generally the case.
We have replaced one question about structured notes with perhaps another one on options – given that options do not pay a dividend, are holders of these products getting shafted? After all, the reference security does pay a dividend.
To understand why not, we first have to understand that option values are calculated based on the forward price of the reference security. (For simplicity’s sake, we are focusing on European options, which are only exercisable at maturity and are the option type most often used in structured notes.) By way of background, when Company A pays out a dividend, the value of Company A declines by that dividend. For example, if Company A is worth $100 and pays out a dividend of $10 to its owners, it will now be worth $90. If there were 10 shares of stock outstanding at $10 per share, the dividend would be $1 a share and the value of the stock would become $9. When a dividend is paid out in the market, the next day opening will reflect the loss of value as per the example above.
Now, assume that the dividend hasn’t been paid yet. Company A is trading at $10 per share, and is expected to pay out $1 in dividends over the course of the year. Pricing an option on Company A with a one year duration will take into account a forward price of the security of $9 (ignoring interest rates). Thus, option holders are not losing out on the dividend; instead, they are paying a lower price for a call option than they otherwise would have because they are not receiving the dividend. In fact, ignoring the impact of rates, all dividend paying securities have a lower forward price than current price, and thus at the money puts will be worth more than at the money calls.
Note: A great exercise to see this in action is to ‘synthetically’ sell the stock through selling the at-the-money call and buying the at-the-money put and comparing the value (inclusive of the strike value) to the stock price. The difference in value should equate primarily to any dividend payments between spot (today’s stock price) and expiration of the options, with the rest of the difference equal to rate of borrow (interest rate) and spread. Try a relatively low volatility dividend stock like GE for instance.
Structured notes therefore take into account the dividend through the way options are priced, incorporating the forward price of the security. (Indeed, the Black-Scholes formula, which contributed to the ability to quickly price options incorporates the dividend.) If a structured note is short a put and long a call, and the reference security is a dividend paying security, the at-the-money put will be worth more than the at-the money call with the security trading at the strike level, resulting in a credit to the investor.
Similarly, the investor receives credit for taking on the risk of the structured note, which after all is a senior unsecured credit of the issuing bank, rather than purchasing the underlying security which does not have issuer risk. The issuer will utilize these credits in creating some other sort of beneficial characteristic for the investor and/or covering the fees for distribution and manufacturing of the product.
In conclusion, while structured notes do not typically pay dividends to investors due to the way they are designed and priced, it does not mean that investors are being cheated. The building blocks used to construct a structured note simply do not include dividends so neither the issuer or investor receive payment streams associated with dividends.