This may be a stupid question, but does this derivative exist (and if not, why)?
Preface: I'm just a lowly 17 year old college freshman, so sorry if this question ends up being 10x stupider than I could imagine.
The problem: With the horrible bond market today, there aren't many places investors can find a security with a good yield that is reliable. It seems that in today's market it is almost better to try your luck with dividend stocks instead of bonds even with the inherit risks of stock over bonds. However, that lends itself to a new problem: risk. Older people and more conservative investors just want a steady flow of income that does not fluctuate too much or change on a quarterly basis like dividends can.
The solution: Investor A owns 100 shares of AT&T. Investor A is very conservative and is just looking for a steady dividend, but can't find a comparable bond that doesn't have a ridiculous premium. Investor A is weary that AT&T stock price may fluctuate or that the dividend may increase. That's where Investor B comes in.
Investor B says to A that he'll guarantee a 4% dividend on shares of AT&T at the current share price of 34.64/share for an entire year. That means that every quarter, Investor B pays A 1%, a total of $34.64 ($.346/share). This guarantees Investor A's dividend, which is exactly what he wants -- the risk is neutralized essentially. The only thing A has to worry about is a stock price drop, but his dividend for the next year at least won't be affected.
Scenarios:If the price of AT&T and the dividend stay the same, investor B will make a 1.2% premium on the dividend. Since the investor makes 5.2% that year in quarterly payments, he makes $46/quarter, gives the investor $34.64/quarter, and has a profit of 32.79%.
If the price of AT&T halves immediately and stays the same for the remaining year, and dividends remain 5.2% (for the sake of calculation) investor A still gets $34.64 per quarter from B, but B has to cover his losses. Since the dividends from AT&T are only $23/quarter now, he has to cover the rest and pay investor A $13.64/quarter.
If the dividend of AT&T rises to 6% and stays at that for the rest of the year while the share price stays the same, Investor B gets $51.96/quarter in dividend money from AT&T and pays out the same $34.64/quarter to the investor, and books a profit of 50% (profit moves with the increase of dividend by 50% from 4% to 6%).
Pros and Cons:
Pros for Investor A:
- Dividends stay the same -- meaning that there's a steady stream of income for the investor.
- If the stock price or dividend decreases, they don't lose out on the dividend.
Cons for Investor A:
- If the stock price or dividend increases, they lose out on the opportunity for more money.
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Pros for Investor B:
- Opportunity to make a profit WITHOUT an initial investment (sort of similar to writing a naked call or put). They don't need the money to own the security.
- Opportunity to make a profit if the dividend in $ stays above a certain point.
- Limited downside: The investor can only lose $36.64/quarter if AT&T goes bankrupt. They can't lose more.
- Theoretical unlimited upside: The dividend could technically increase much higher and the share price could increase much higher, so it could be infinite (in theory).
Cons for Investor B:
- Complete loss of original investment if the stock goes bankrupt.
- Presumably this would be subject to margin requirements, so you would need some cash or securities to fund this.
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inb4's:
Why not just choose preferred shares?
- Because then you need to actually have a lot of capital to get the dividend. That reduces your ROI.
It's called a swap.
- Sort of, but I don't know of a single way that I, an individual investor, can do this. There's also no market as of now.
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So does this exist already, or is there some way to effectively do this?
If not, why doesn't this exist? Has nobody done it yet, or is there just not a market like I think there would be?
If investor A is very conservative, a drop in share price is the main risk he would be concerned with. To protect against that risk, he can simply buy a put....for a price.
I don't necessarily think so though. What about all the older people who are living off of portfolios of dividend stocks? I think they'd primarily be concerned about getting their monthly/quarterly check. I'm not saying that it's a derivative that lots of people use, but I definitely think that it could benefit people looking to minimize risk with their dividend payout, and people who'd like to speculate on it.
sounds like you're converting the dividends into a high-yield, high-risk bond with fixed payments and the underlying is not backed by the government, but subjected to lots of volatility in investor B's portfolio. Like a high credit-default bond.
By risk neutral pricing, if A expects a 4% returns, then B would demand a 4% premium. Thus older people may be expected to pay 2-3%-ish premium, discounted over the payments. Now how the security is priced is determined by B's expectation of future prices of the security, which is reflected into bid-ask prices. Perhaps, I would expect the spread to be wide.
Again, come ex-dividend, the stock prices usually drops by the same amount, so effectively the value of the stock remains the same over the long-term.
Because of its high risk nature, it may exist as an OTC product, may not be widely traded and not listed on exchanges.
Next topic: swaps and CDS
I don’t think this is dumb at all. It certainly made me think. I think the problem is this: there’s almost no upside for investor A. You’re asking them to bear the entire capital loss risk of owning common equity (yes I get that there’s one years guaranteed income, but they’re still screwed after that) without the upside, which is capital appreciation. You’re essentially asking the investor to swap 10% (or whatever) expected returns, with 4% guaranteed returns while still bearing the same long-term cost of capital as the 10% expected return.
I also think the stipulation that a retail investor must be able to access a market like this is a far larger barrier than you’re assuming. Most derivatives aren’t actually accessible to the vast majority of retail investors because of general liquidity issues. There would need to be huge demand for this as well as a fairly organized exchange to make it commonly available.
Edit: by the way a covered call has a pretty similar payoff graph for investor a although there are obviously distinctions
I could be wrong, as I am not exactly an equity derivatives maven... However, it appears to me that this here looks might similar to a dividend swap.
http://en.m.wikipedia.org/wiki/Dividend_swap
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