By now, most investors the world over will be aware of the disruptive events that occurred on May 6 — a day that has come to be known as the ‘flash crash’.
What most investors might not be so well aware of, however, are the strange occurrences that transpired the day after in the fledgling exchange traded dividend futures market in Europe.
Theo Casey, columnist for MoneyWeek and editor of The Fleet Street Letter, has penned a very interesting account of the fallout, dubbing it catchily ‘Dividend Black Friday’.
Casey’s main point was that while equity markets quickly recouped losses following the crash, this was not quite the case for dividend futures.
A point well demonstrated by the trade in one of the most liquid contracts, the 2012 EuroStoxx 50 Index dividend future:
As Casey notes in Futures and Options Intelligence, a derivatives news service, the futures’ reaction to the flash crash may have exposed some key weaknesses in the product. Some are clearly the sort of generic issues associated with many new products: illiquidity, wide spreads, seasonality etc.
But others — the propensity for mispricing, for example — may be more worrying.
As Casey notes, this not only makes them rather unattractive to anyone sensitive to mark-to-market risk, it exposes to what degree the asset class may currently be the playground of structured product hedgers.
He explains as follows:
According to one hedge fund manager, active in this market, it was forced selling by structured products dealers that pushed prices lower. One can liken this market to Japanese equities, where structured products play a uniquely large part, primarily because of the demand for income-giving products after so many years of near-zero interest rates.
Much like in Japan, European structured products dealers need to hedge vega (sensitivity to volatility) and, where relevant, dividend risk. As these dealers tend to be on one side of the market – paying fixed sums to receive dividends – the quantity of hedging they need to do can move the market. Therefore even the ebb and flow of money in and out of structured products can be felt in the dividend market.
Unlike in Japanese equities, there is no widely reported monitor of structured product trading activity in dividend futures. This can leave investors blind to the real causes of price movements.
As to why May 6 was such a trigger, the theory is that the day’s exceptional trading pushed many equity structured products past triggers, into automatic wind-down. Dealers then had to scramble to unwind their hedges, including on dividends.
Casey puts it this way:
Now they were weighing on the market the other way, wanting to receive a fixed amount and sell dividends. Naturally prices plummeted. Interestingly, although the 2010 contract did not budge much, as its outcome is fairly secure, the 2011, 2012 and 2013 futures move in lockstep.
The implication of all this is that the market may be an arbitrageur’s dream. Especially if you consider that it was possible to take advantage of the mispricings up to two months after the flash crash aberrations.
That said, Casey concludes by citing GMO’s Jeremy Grantham:
As GMO’s Jeremy Grantham extols: in a rational market, structural selling pressures unrelated to value create mispricing opportunities, into which sensible money will be drawn. This is what happened to equities in the wake of the flash crash. Fast forward three months and the mispricing, albeit to a lesser extent, still persists in dividend futures. Good news if you’re the kind of investor who thrives on mispricings. But if you bought the 2012 contract in February or March, you may be sitting on a paper loss for a long time.
Which probably means there are wider implications on the dependability of implied volatility rates derived from the asset class too.
Related links:
Back to the future in shorting Spain – FT Alphaville
What are stock index future curves telling us? – FT Alphaville
James Montier on the value of dividends – FT Alphaville
Of fat tails and mean reversion – FT Alphaville