The Impact of Equity Dividends on Option Pricing and Wrong-Way Risk: Tales from the Trading Floor Trenches
Level 2 - Intermediate Vol Trader
In today's post, we would like to dive into more detail on the impact of the equity dividend yield on option pricing and how this can materially impact the P/L of your trading portfolio with some examples of spectacular losses at Wall Street trading floors in the past.
We will also go into detail on the concept of Wrong Way Risk, and how exposure to Dividend Risk can be compounded into a wrong way risk, especially in markets where there is a high degree of structured product issuance. From this we can see the importance of keeping abreast of the scale and growth of activity in the structured products markets as an important metric as we think about second order risk in our portfolios, as well as for providing potential trade ideas, skills which any experienced options trader will possess. Let's dive in!
For complete beginners to the impact of equity dividends on the P/L of the option holder, take a look at our previous Level 1 post about option pricing here.
The risk associated with dividends in an option portfolio tends to increase in proportion to both the average maturity of the options held and the average moneyness of the portfolio. This implies that as the average maturity of the options portfolio extends or as they become more in-the-money, the portfolio risk due to potential dividend payouts becomes greater. Many option traders mitigate their exposure to delta risk by hedging with spot positions (for example, an FX options trader will hedge with cash FX and an equity options trader will hedge with the underlying stock), however, this leaves the forward risk unhedged (which incorporates dividend and interest rate risk). The reason they do this is because of greed.
The options trader wants to retain as much of the client markup on the deal as possible, and it is much cheaper (lower bid offer spreads) to delta hedge with spot than with the forward, especially for longer-dated and emerging market currencies (liquidity is worse for both longer-dated forwards and forwards on EM pairs). The options trader is usually mandated to hedge the forward risk with the bank’s own forwards desk in order to internalize flows, and the forwards trader, when learning that the options trader has just won a juicy structured product deal, and is a captive client (has to deal with the internal forwards desk), will often charge an egregious bid offer spread to hedge the forward. Ultimately what ends up happening is that the options trader will hedge with spot and leave the dividend risk unhedged.
Even in cases where forward risk is hedged, it is generally more challenging to hedge against dividend risk compared to interest rate risk due to the greater liquidity and availability of interest rate derivatives in the market. As a result, market participants often find it easier to manage and hedge interest rate risk, which is more readily tradable, while dividend risk presents a greater challenge due to the limited availability of dividend derivatives and the complexities associated with pricing and trading them effectively.
In many equity option markets, clients who do not engage in delta hedging often take the position of outright buyers of calls or sellers of puts. As a result, market making desks are left with a similar risk exposure, namely, being long dividends. However, market makers have a limited capacity to mitigate this risk by engaging with hedge funds through instruments like dividend swaps. These swaps provide a means for market makers to transfer the risk associated with dividends to hedge funds, thereby managing their overall risk exposure more effectively. However, they tend to be only available on liquid equity indices such as the S&P 500 and not single stocks, so there is still a lot of dividend risk unhedged.
In part 2 of this series, we will go over the concept of Wrong Way Risk, and how this manifests in the structured products market in relation to dividend risk on equity options and FX forward risk in the context of FX structured products! Hope to see you there!
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