Stochastic Proportional Dividends

Working Paper

Hans Buehler, Anissa Dhouibi, Dimitri Sluys

JP Morgan Equity Derivatives Group

Quantitative Research
London

[email protected]
[email protected]
[email protected]
First draft: January 2010 - This draft: December 2010,
Revision 1.013

Abstract
Motivated by recently increased interest in trading derivatives on div-
idends, we present a simple, yet efficient equity stock price model with
discrete stochastic proportional dividends. The model has a closed form
for European option pricing and can therefore be calibrated efficiently to
vanilla options on the equity. It can also be simulated efficiently with
Monte-Carlo and has fast analytics to aid the pricing of derivatives on
dividends. While its efficiency makes the model very appealing, it has the
twin drawbacks that dividends in this model can become negative, and
that it does not price in any skew on either dividends or the stock price.
We present the model and also discuss various extensions to stochastic
interest rates, local volatility and jumps.

Keywords: Options on Dividends, Stochastic Dividends, Dividend Yield

1 Introduction
The recent years have seen an increased interest in trading more directly one
of the most basic features of equity stock prices, its dividends. Dividends are
comparable to coupons of a bond since they provide the equity holder with a
stream of income. The main difference, of course, is that a company can decide

Electronic copy available at: http://ssrn.com/abstract=1706758

how much dividend it will pay, hence the dividend amounts are a function of
the company’s performance.
In the derivatives worlds, dividends have traditionally been traded either di-
rectly via forms of over-the-counter (OTC) equity swaps or implicitly by trading
calendar spreads of forwards. The latter in particular allows to trade the real-
ized dividends against the assumed, or “implied”, dividends. Starting in 2001,
dividend swaps have become a popular way for dealers to hedge their dividend
exposure [11]. A dividend swap pays directly the aggregated value of all (gross)
dividends a company pays in exchange for the initially agreed strike price.
The next step in listed product development was to introduce dividend fu-
tures on an exchange. The first such product, the “Dow Jones EURO STOXX
50 Index Dividend Futures” was introduced by Eurex in June 2008 [1]. Figure 1
shows the growth of the volume of dividend futures over the last two years.

Figure 1: Growth of dividend future volumes since beginning of 2009.

The culmination of this process so far was the introduction on May 25, 2010
of options on the “S&P500 Annual Dividend Index (DIVD)” and the “S&P 500
Dividend Index (DVS)” on the CBOE [12], and the introduction on the same day
of options on both “Euro STOXX50 Index Dividend Futures (FEXD)” and the
“Euro STOXX50 Index Dividend Points (DVP)” on Eurex [2]. The exchange
traded contracts have the potential to improve price discovery for the volatility
market on dividends substantially.
Aside from the listed market, there also the market of OTC derivatives.
Here, the potential for structuring ideas around dividends are wide: options on
dividends are one way to expresss a view on dividends, but other products such
as Dividend Yield Swaps and Knock-Out Dividend Swaps can give a much more
tailored exposure to the realized dividends of an index or a given equity.
In addition, there is also a natural interest in products which give exposure
to the “yield gap” between the yield on bond investments and the yield derived
from dividends.

Electronic copy available at: http://ssrn.com/abstract=1706758

Pricing with Dividends
In the light of these developments, it is surprising to find that there is actually
not much literature on the modeling of dividends for derivatives pricing and risk
management, except on the question on whether these should be proportional
to the stock price, fixed in cash or a mixture of the two.1 Beyond this, the only
reference to our knowledge on modeling the dividends of an equity is implicitly
given by Gaspar’s theoretical work [7] on modeling the entire term-structure of
the forward curve as a diffusion in an Hilbert-space. This “HJM-approach” is
related to a version of our model where a dividend yield is modeled instead of
a stream of discrete dividends.
With this article, we aim to contribute to the modeling discussion on div-
idends with a model where dividends are discrete and proportional; the (log-)
proportionality factor itself is given by a function of an Ornstein-Uhlenbeck
process, meaning that the resulting dividend yield is mean-reverting around a
long-term average yield level. While the drawback of using a normal process for
the proportionality factor is that it can lead to negative dividends, the upside is
that the model remains very tractable: pricing vanilla options on the equity for
the purpose of calibration, simulating the model with Monte-Carlo and evaluat-
ing future forwards are all efficient operations. This gives the model the flavor
of a robust “Black & Scholes”-style workhorse for pricing various variants of
structures on dividends.

This article is structured as follows: first, we will introduce our setup and
a set of interesting payoffs. We then present our main model and discuss its
properties as well as a calibration procedure which we apply to market data
for STOXX50E. In the next section we show how an efficient Monte-Carlo
scheme can be implemented and how we can compute dividend future prices
on the given Monte-Carlo paths. We also compute some sample option prices.
A final section discusses extensions of the model to stochastic interest rates,
credit and jump risk, and local volatility (with numerical methods). The sec-
tion concludes with a comment on the connection to Gaspar’s HJM-framework
for the forward curve.
An appendix contains most of the actual calculations.

Acknowledgements
We are very grateful for the help of Christopher Jordinson, now at UBS, many
of whose ideas are incorporated in the model we present here. His input was
crucial to the development of the model.
1 For a thorough review of this setting, cf. Bermudez et al. [3] and, in more detail,

Buehler [6].

3
2 Modeling Dividends
We aim to model an equity stock price process S = (St )t under an interest
rate process r = (rt )t and with effective borrowing costs of µ = (µt )t . RBoth are
t
assumed to be deterministic. For notional convenience
Rt we write Rt := e 0rs −µs ds
for the drift factor of the equity and Bt := e 0rs ds for the cash account.2
To model the dividend stream of the equity, we assume that the stock is
going to pay N random dividends ∆ = (∆i )i=1,...,N at dividend dates 0 < τ1 <
· · · < τN .3 (We will assume that the dividend dates are fixed and known in
advance.) Modeling the dividends of the equity as stochastic means modeling
each paid dividend ∆i as a random variable which is “known” by the dividend
time τi .4

Dividend Derivatives
A dividend swap on the equity between the dates T1 and T2 pays the accumu-
lated dividends between these two dates against a fixed strike K, i.e.
X
∆i − K .
i:T1 ≤τi ≤T2

Similarly, an option on realized dividends, or in short OOD, is a vanilla payoff

on the same quantity, i.e. in the case of a call on realized dividends
 +
X
 ∆i − K 
i:T1 ≤τi ≤T2

where we used the notation x+ := max(0, x). Note that dividend futures usually
pay the realized dividends of the respective underlying index. Hence, an “option
on a dividend future” is effectively also an option on realized dividends for the
period of the future.
More advanced OTC products on dividends are structures, where the payoff
of the dividend is linked to the performance of the equity itself. One example is
a knock-out dividend swap, i.e. a dividend swap which knocks out if the equity S
trades below a given barrier. The payoff for this product is
 
X
1 mint:T1 <t≤T2 St <B  ∆i − K  . (1)
i:T1 ≤τi ≤T2

2 We do not model the possibility of default here, but an extension to the case of a deter-

ministic hazard rate model is well within our framework, c.f. the discussion in [6].
3 For ease of exposure we assume that the payment dates are equal to the ex-div dates. An

extension to separate ex-div and payment dates is straight-forward.

4 An exception here is Japan, where dividends are usually announced after the ex-div date.

4
Another example is a dividend yield swap, which pays the sum of realized divi-
dends over the monthly average spot of the equity:
∆i
P
P i:T1 ≤τi ≤T2P (2)
k:T1 ≤tk ≤T2 Stk

where (ti )i are monthly fixings (other variants scale the realized dividends by
the stock price at the end of the period, or divide each dividend by the stock
price of the previous trading day).
As mentioned before, there is a recent interest in rates-dividend hybrid prod-
ucts, for example those which allow to manage an exposure to the difference in
dividend and bond yields. Figure 2 shows that the implied yield on equity is
recently higher than the yield which can be derived from investing in bonds.
A good example of a product which allows to hedge this “yield gap” would be a

Figure 2: Dividend yield is high in both absolute and relative terms compared to
bond yields.

“Leveraged Div Yield Swap Certificate” which basically pays coupons which are
a difference between interest rates and dividends: We simplify the product for
the sake of simplicity. The simple version works as follows: define the realized
dividend yield between two times T1 and T2 as
1 X
ryld(T1 , T2 ) := ∆i
ST2
i:T1 <ti ≤T2

and let CMSt (1Y ) denote the 1Y libor rate observed at time t. Then, the
product pays
!
X n o
max 100% + 5 CMSt (1y) − ryld(t, t + 1y) , floor
t=1y,2y,3

where the floor is, for example, 30%. In this form, the product provides a
positive exposure to a drop in dividend yield vs. interest rates.

5
 While we will mainly discuss our model in a deterministic interest-rate envi-
ronment, section 3.1 explains how it can be incorporate stochastic interest rates
in order to risk manage rates-dividend hybrids.

The Equity and its Dividends

To model an equity process with a stream of stochastic dividends, the challenge
is to find a distribution for the dividends which still allows pricing and risk
management of options on the underlying efficiently such that the model can be
calibrated easily to observed prices of equity vanilla options.
To approach this topic, we first assume that we face an idealized liquid
market of dividend swaps, which allows us to forward-trade any dividend prior
to its dividend date. In particular, we assume that there is at any time t a
market for the dividends with dividend dates past t. We denote the forward-
price at time t for the ith dividend accordingly by ∆it . As a consequence of our
assumptions, its value is given under any risk-neutral measure as

∆it := Et ∆i .
 
(3)

Note that the process (∆it )t∈[0,τi ] is a (local) martingale.

With the setup of the previous section, we can deduct a basic shape of any
equity model which is consistent with a given dividend stream: basically, the
assumptions that dividends can be traded means that the stock price cannot
drop below the properly discounted value of future dividends at any point.
Following the same arguments as laid out in Buehler [6], standard no-arbitrage
replication arguments imply that the stock price process has to have the form
( )
X ∆i
t
St = Rt S̃0 Xt +
R
i:τ >t τi
i

with S̃0 = S0 − i ∆i /Rτi for a (local) martingale X. Accordingly, the forward

P
at time zero of the process is given as
 
 X ∆i 
0
Ft = Rt S0 − .
 R τi 
i:τi ≤t

Black & Scholes

The standard extension to Black & Scholes’ model is the classic case where the
dividend is proportional to the equity, i.e.5

∆i0
 
i −Di i
∆ = Sτi − (1 − e ) with D := − ln 1 − . (4)
Fτi −
5 This follows since both Fτi − e−Di = Fτi and Fτi − − ∆i = Fτi have to hold.

6
The corresponding stochastic model is then given by

St = Ft Xt ,

where X is a log-normal model with “pure equity” volatility term structure σ.

Its SDE is given as
dSt X
= (rt − µt ) dt + σt dWt − (1 − e−Di ) δτi (dt) (5)
St
i:ti ≤t

(we use δx (·) to denote the Dirac-measure in x). In this model, the dividend
stream is obviously stochastic – it exhibits the same volatility as the underlying
equity.

Stochastic Proportional Dividends

The model we want to propose here is given as well in the form
dSt X
= (rt − µt ) dt + σt dWt − (1 − e−di ) δτi (dt) (6)
St i

but the dividend ratios di are random: to model them, we use an Ornstein-
Uhlenbeck process
dyt = −κyt dt + ν dBt
and set
di := (Di + Ei yτi ) + Ci (7)
where Di is the Black & Scholes value for the proportional dividend as defined
in (4). The constant Ei allows to blend between normal and log-normal volatility
for the dividend yield by using Ei ≡ 1 or Ei ≡ Di , respectively. Finally, the
constant Ci is determined by matching the forward such that E[St ] = Ft for
all t using an analytical procedure; see appendix A.2 for details.

Remark 2.1 Our model can easily be extended to incorporate a fixed cash-
dividend part for each dividend. For example, we could assume that a fraction αi
of each dividend ∆i is fixed in cash. Compared to (4), the stochastic dividend
in such a model becomes

∆i = Sτi − (1 − e−D̃i ) + (1 − αi )∆i0 .

for a suitable D̃i which ensures that the forward of the process is correct. Ap-
pendix A.1 provides some more details.
To motivate our model choice, let us define the “forward yield” between T1
and T2 , seen at a time t, as the sum of the expected dividends between the two
reference times, divided by the current spot level:
i
P
i:T1 <τi ≤T2 ∆t
ȳt (T1 , T2 ) := .
St

7
It is easy to see that in the current model, each dividend has the property
that log ∆it /St is an affine function of yt , which implies that the log-yield
log ȳt (T1 , T2 ) is also approximately proportional to yt ,

ȳt (T1 , T2 ) ∼ ayt + b (8)

for some constants a and b.

Looking then at historical data, we indeed see that the log-forward yield
seems to mean-revert around some fixed mean. During “the great moderation”
of the early 2000’s in particular, we have seen a very stable pattern of mean-
reversion. Even though this pattern has unsurprisingly been severely disturbed
with the onset of the financial crisis and, in particular, Lehman’s default in
October 2008, the structure has since vaguely recovered, albeit to a regime with
a lower level of average implied yield. Figure 3 illustrates this point. In general,

Figure 3: The graph shows historical log-dividend yields for future periods. For
example, the 9Y/10Y point refers to the floating maturity forward dividend swap
between 9Y and 10Y, divided by the spot at the observation point.

the assumption of a mean-reverting dividend yield in a non-distressed market

is a very natural from an economic point of view, in particular if applied to
indices.

Model Properties
The first important observation is that the model’s stock price is log-normal:
its explicit form is
R τi −κ(τ −s)
{Ci +Di +Ei [y0 e−κτi +ν
Rt
σ dWs − 12 0tσs2 ds− i:τ dBs ]}
R P
i
0 s 0 e
St = Rt S0 e i ≤t ,

8
with log-variance
 
t  −2κτj Z τi 
1−e
Z X  X
Var(t) = σs2 ds+ Ei Ej ν 2 − 2ρν σs e−κ(τi −s) ds .
0  2κ 0 
i:τi ≤t j:τj ≤τi
(9)
This means that if we are given the dividend parameters y0 , κ, ν and ρ, then
we can bootstrap a piece-wise constant forward volatility (σk )k to matching an
observed term structure of Black & Scholes (spot-) implied volatilities (Σk )k
defined for maturities T1 < T2 < · · · (see appendix A.4 for details). Since this is
an analytic procedure, this can be performed on-the-fly in order to ensure that
the model always reprices a selected term structure of observed market implied
volatilities on the stock price.
The task remains to determine reasonable values for the dividend volatility
term structure via the two parameters ν and κ, and the correlation ρ between
dividend yield and the spot price (the initial value y0 can be left at zero). For
liquid indices, we can calibrate these parameters to ATM prices of options on
dividends. As an example, we have used internal JP Morgan price indications as
of 14 October 2010 for options on dividend prices for STOXX50E to calibrate
the model. The prices provided for Dec10-11 and Dec11-12 ATM options on
dividends are quoted in terms of Black & Scholes implied volatilities6 as 7.8%
and 16.1%, respectively (the dividend swaps traded at 114.0 and 109.2).
To calibrate our model to just two maturities of options on dividend prices,
we have fixed our correlation7 at −95% and then run a simple minimizer which
yielded a dividend volatility of ν = 27% and a mean-reversion speed of κ = 1.4.
The resulting ATM implied BS volatilities for the two maturities in the model
are then 7.9% and 16.1%, respectively. These have been calibrated using a
Monte-Carlo simulation with 10,000 paths.
In figure 4 we show the calibrated model prices against market price indica-
tions for options on dividends. The data show that the market price indications
exhibit far more skew than the model is able to replicate. This is in line with
the model’s basic structure where the sum of dividends is roughly log-normal,
hence we do not expect much skew. Figure 5 shows the entire implied volatility
surface for options on dividends.

The Role of Dividend Correlation

Correlation plays a particular role in this model. Recall that the yield in the
model is approximatively an affine function of yt , cf. equation (8). Figure 6
illustrates the impact of a change of correlation on the relation between spot
and yield – as expected, a positive correlation implies a positive yield with
raising spot while a negative correlation implies a drop in yield.
6 I.e. the forward in the Black & Scholes formula is set to the dividend swap fair strike and

then the respective implied volatility is calculated from observed market prices.
7 The very negative correlation is not only necessary to be able to provide a decent fit to

the observed market prices; it is also economically sensible as we will explain below.

9
Figure 4: Prices for options on dividends; the model is calibrated against the ATM
strike of the market price indications. The data has been priced as of mid October 2010.

Between the two, the latter is a much more realistic assumption since an
increase in spot is not usually immediately followed by an increase in dividend
levels; in a sense, the negative correlation between spot and dividends “sta-
bilizes” the level of dividends and gives them some “constantness”. Figure 7
shows visually how realistic paths generated by a negative correlation regime
look – until the crisis in September 2008. After the crisis, however, the two
were more ‘correlated’: dividends were cut along with the fall in stock prices.
More recently, the market has recovered and we see again a more anticorrelated
behavior.
This means that the correlation in our model should generally be significantly
negative in order to produce the well-known effect that short term dividends
are much more certain than longer term dividends. This is also borne out of
the market prices for options on dividends: the above calibration only works
well for very negative correlations. If the correlation is set at, say, -50%, then
there is no combination of mean-reversion speed and dividend volatility which
fits the provided market.

Negative Dividends
While most of the properties of our model are appealing, the model’s structure
also reveals its main drawback: the fact that the dividends themselves can
become negative. This happens if di becomes negative. The probability of this
happens at a dividend date τi is
" r #
1 − e−2κτi Di + Ci −κτi
P Yν ≤ − y0 e
2κ Ei

10
Figure 5: The “implied volatility” surface for options on dividends in our model.
Strikes are provided as offset to 100% ATM.

where Y is standard normal. For the calibrated model above, the annual prob-
ability of having negative dividends is around 1% in the model as is shown
in figure 8. The same figure also shows that the size of the negative dividends
in relation to the total forward is (predictably) small.
However, we think that the advantage of analytical tractability of the model
far outweighs the downside of having potentially negative dividends.

2.1 Using the Model

For most derivatives on dividends, we will need to revert to numerical methods
to compute the value of the payoff and risk manage it. We will here discuss
briefly how to implement an efficient Monte-Carlo and will show how the model
prices some options on dividends.

In order to simulate the model (6), we assume that we have some “observa-
tion dates” 0 < t1 < · · · < tn of interest at which points we wish to evaluate
our payoff; for ease of exposure we assume w.l.g. that these dates include all
dividend dates in the respective period.
A convenient feature of our essentially normal model is that we do not need
to use Euler to simulate our SDE because the model is in fact normal between
two of the observation dates. Assuming constant equity vol of σk between tk−1
−2κdtk
and tk = dtk + tk−1 , the variance of the increment dy is Σyk = ν 2 1−e 2κ , the
variance for the equity increment is ΣSk := σk2 dtk and the covariance between

11
Figure 6: Impact of correlation on the relation between spot and yield; the graphs
show expected dividends between Dec 11 and Dec 12 divided by the spot at observation
time. Dividend volatility was 50%, correlation -80% and mean-reversion speed 1.

Figure 7: Visual comparison of a negative correlation case above visually with historic
data.

−κdtk
the two is ρνσk 1−e κ , which means that the correlation is

1 − e−κdtk
ρk := ρ √ q .
1 − e−2κdtk 12 κdtk

Hence, if we chose a iid sequence of standard normal random variables (Yk , Ŷk )k ,
we can simulate on big step between tk−1 and tk using
q  q 
−κdtk y 2
ytk = ytk−1 e + Σk ρk Yk + 1 − ρk Ŷk
p 1 Fk
log Stk = log Stk−1 + σk dtk Yk − σk2 dtk + log − (Ek ytk + Ck ) .
2 Ftk−1

(We used a slightly lax notation here: the Dk , Ek and Ck are either the relevant
coefficients from a dividend payable at tk or zero.)
Another strength of the model is that it is possible to efficiently calculate

12
Figure 8: Illustration of the risk of having negative dividends for the calibrated
model: the graph shows the annual probability of having negative dividends (around
one percent) and the ratio of the expected negative part over the full expected sum
over the same period, which hovers around 0.5%.

the forward price of the equity as a function of spot and the driving Ornstein-
Uhlenbeck process u at a given future time efficiently since it has the form
RT At (T )yt +Bt (T )
Ft (T ) := Et [ ST ] = St e
Rt
for some deterministic functions A and B (see appendix A.3 below). This is
important because it allows us8 computing future expected dividend values on
a given Monte-Carlo path efficiently using
Rτ`
∆`t = Ft (τ`− ) − Ft (τ` ) = Ft (t ∨ τ`−1 ) − Ft (τ` )
Rt∨τ` −1
(x ∨ y := max(x, y)). Hence, the model permits efficient access to pricing divi-
dend swaps analytically within a Monte-Carlo simulation. This means we can
use the model to price and risk manage not only options on realized dividends,
but also on more involved trades which depend in value on futures on dividends.
As an example, figure 9 shows a sample path of both stock price and a div-
idend future generated by the model.

To illustrate the pricing of derivatives with the model, we used it to price

two types of products with the parameters estimated before for STOXX50E.
The first product is the aforementioned Knock-Out Equity Swap (1). Using the
same calibration as above, and a barrier of 90% of initial spot,9 we get
8 We
P
use the fact that by definition Ft (T ) = RT /Rt (St − i:t≤τi ≤T Rt /Rτi ∆t (i)).
9 In practise, this model should not be used to price barriers due to its lack of skew for the

equity. Below is a brief comment on how to incorporate skew.

13
Figure 9: A Monte-Carlo path of spot and expected dividends divided by spot where
the dividends are computed from the observation time to a fixed maturity (Dec 13).

Dec10-11 Dec11-12 Dec12-13 Dec13-14

35.1 46.9 45.9 47.6

Another interesting product is the Dividend Yield Swap (2). It pays the sum
of realized dividends over the monthly spot price average.
Our model gives us:
Dec10-11 Dec11-12 Dec12-13 Dec13-14
4.13% 4.09% 3.97% 3.97%

3 Extensions and Related Models

We briefly want to give some overview over possible extensions to the current
model.

3.1 Stochastic Interest Rates

An interesting aspect of dividend modeling has to be the relation ship between
dividends and interest rates. From an economic point of view, both rates prod-
ucts and dividend-paying equity play a similar role in providing investors with
a stream of income. Consequently, we can assume that the market’s dividend
yield is related to the level of interest an investor can earn by buying just a
coupon-bearing bond.
While we will not discuss the economic situation much further here, we would
like to point out that the current model can easily be adapted to the standard
Hull & White interest model [9], and that it retains its analytical tractability
since the distribution of the stock price remains log-normal.
To start with, let us assume that we can observe at time zero a market of
zero coupon bonds (Pt )t for each maturity t. We are going to model the interest

14
short rate as an Ornstein-Uhlenbeck process by setting:

drt = (θt − qrt ) dt + ξt dWtr .

Mean-reversion speed q, the interest volatility ξ and the correlation structure

between the equity and the short rate are free parameters have to be calibrated
or estimated. The level of mean-reversion, θ, is implicitly given by fitting the
model to the observed zero coupon bond term structure by stipulating
h Rt i
!
E e− 0rs ds = Pt

(in practical applications, one would never actually calculate θ but use it only
in integrated form; see [3]). Given our Hull & White model, we can now define
the equity process via, once again,
dSt X
= (rt − µt ) dt + σt dWt − (1 − e−di ) δτi (dt)
St i

with di given again as in (7) with adjusted C’s. Since r and therefore any
integral over it are normal, it follows that the stock price process in this joint
Hybrid model is still log-normal. Consequently, the analytic tractability of the
model is preserved and it is a very convenient candidate if we want to price
joint rates-dividend derivatives. We even maintain the ability to run an efficient
Monte-Carlo by using the methods discussed in Brockhaus et.al. [5], page 36.

Remark 3.1 Both our original and our rates/dividends hybrid model allow the
introduction of several Ornstein-Uhlenbeck factors to drive the respective curves;
see also Hull’s description for the 2-factor rates model in [8].

3.2 Jump Risk, Crash Risk, Credit Risk

Handling plain credit risk within a deterministic intensity model is straight
forward following the recipe in [6]. If one is interested in adding less drastic
jumps to the equity process which also impact the dividend, then the classis
approach by Merton [10]. One point of consideration is the behavior of the
yield if the equity exhibits a sudden drop. We would assume that a sudden
drop in the spot price will also lead to a drop in yield. This can be seen very
well in figure 3 on page 8 which shows that the stock market drop in October
2008 lead to a substantial drop in dividend yield as well.
To model such a relationship, let us consider series of normal crash or jump
scenarios (γj )j=1,...,M for the stock price process, each with mean mj and volatil-
ity sj , and driving Poisson processes (N j )j with crash intensities (λj )j . We also
assume we have corresponding shock scenarios (gj )j for the dividend yield.
The diffusion for the stock price is then
 
M
dSt X X
= (rt − µt ) dt + σt dWt − (1 − e−di ) δτi (dt) −  γj dNtj + λ̃j dt .
St i j=1

15
 1 2
with λ̃j := λj (e−mj + 2 sj − 1). In order to incorporate synchronous jumps
into the dividend yield as well, we additionally rewrite our driving Ornstein-
Uhlenbeck process as
M
X
dyt = −κyt dt + ν dBt − gj dNtj .
j=1

This model has the desired properties of synchronous crashes in equity and yields
while it maintains enough flexibility to be adapted to “small” jumps which do
not affect the yield itself (they will affect the dividends being proportional to
the spot price level). Note that one drawback of incorporating negative jumps
into u is that the proportional dividend factors di are more likely to become
negative.
In terms of analytical tractability this model is once again very convenient:
conditional on the number of jumps for each Poisson-process this model has a
log-normal distribution which means
that it can be used efficiently using Fourier-based pricing for European op-
tions.

3.3 Fitting the Equity Smile

Since the proposed model’s stock is essentially log-normal, it does not have any
skew when pricing vanilla options on the equity. This obvious drawback can
be addressed at least in the case for deterministic interest rates by calibrating
numerically a local volatility function on top of the equity.
The corresponding SDE for the equity is
dSt X
= (rt − µt ) dt + σt (St ) dWt − (1 − e−Di ) δτi (dt) .
St i

The local volatility function itself can then be calibrated using forward-PDE
methods such as the one described in [3] for the calibration of a local volatility
function on top of a stochastic rates equity pricing model.

3.4 Stochastic Yield Dividends

One of the main features of our “stochastic proportional dividend” model is that
it keeps the dividend payments to exactly the payments found in the market
data. An alternative is to model a yield on top of the prevalent forward curve:
such a model is given by
dSt X
= (rt − µt − yt − C̄t ) dt + σt dWt − (1 − e−Di ) δτi (dt)
St i

where the Di are the proportional dividends from the Black & Scholes formu-
lation (5), and where the continuous function C̄ is chosen such that the model

16
fits the forward, i.e. E[St ] = Ft .10 While being numerically easier to handle
than the proportional dividend model above, it has the disadvantage that the
yield will often be negative over periods between the input market dividend
dates. As such, the model might be more useful if the equity forward itself is
given as a yield – in fact, this model is related to Gaspar’s HJM-framework [7]
for forward curves which we mentioned in the introduction; it is basically the
normal 1F-version in her framework.
We will not discuss the details of this approach further, but the interested
reader will find that most calculations are either similar or simpler compared to
our proportional dividend model.

4 Conclusions
We have discussed a stochastic dividend model with very tractable analytics for
calibration towards the vanilla market and for the pricing and risk management
of dividend derivatives. To the best of our knowledge, this is the first attempt to
model the dividend stream of an equity in a consistent manner for the purpose
of derivatives pricing. The model’s simplicity qualifies it as a standard tool in
a derivatives library, while the fact that its dividend are not always positive
and that it does not capture the implied volatility skew in either equity or
dividends means that there is clearly a further need for development in the
dividend modeling area.

A.1 Cash Dividends

In order to extend the model to support explicit cash dividends, we follow the
approach in [6]: first, we define for each dividend ∆i are ratio αi which denotes
how much of today’s expected dividend value ∆i0 will certainly be paid (an
extension to support simple credit risk is trivial). The model is then written as
follows: first define an adjusted spot
X
S̃0 := S0 − P (0, τi ) αi ∆i0
i

and a ‘proportional forward’

 
 X (1 − αi ) ∆i 
0
F̃t := Rt S̃0 − .
 Rτi 
i:τi ≤t

Accordingly, we define new proportionality factors

(1 − αi ) ∆i0
 
D̃i := − ln 1 − .
F̃τi −
Rt h Rt 1 Rt 2 Rt i
10 I.e. we use the relation e0C̄s ds = E e 0σs dWs − 2 0σs ds− 0ys ds to find C̄.

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The proportional dividend for a given Ẽi will then be modelled as
 
d˜i := D̃i + Ẽi yτi + C̃i

which gives us the diffusion

dS̃t X
˜(1e − e−di ) δτ (dt) .
= (rt − µt ) dt + σt dWt − i
S̃t i

The stock price is then given as

X
St := S̃t + P (t, τi ) αi ∆i0
i:τi >t

and will, with appropriately calculated C̃i , reprice the forward. The calculations
for C̃ are the equivalent to the one for the model discussed in the text.

A.2 Matching the Forward

Fix some `. We want to compute
h R τ` 1
R τ` 2 P i
(∗) = Et e 0 σt dWt − 2 0 σt dt− j:j≤` dj .

As a first step, we change into the “equity measure” Q under which

dyt = (θt − κyt ) dt + ν dBt .

with θt := σt ρν. Under this measure, we have

h P i
(∗) = EQ e− j:j≤` dj .

Since we have deκt yt = eκt θt dt + eκt ν dBt , we get

Z t Z t
−κ(t−u) −κ(t−s)
yt = yu e + e θs ds + ν e−κ(t−s) dBs .
u u

That means that for any p,

2
EQ e−pyt  Fu = e−pyu K(t,u)−pΘ(t,u)+p Γ(t,u) .
  
(10)

with  R t −κ(t−s)
 Θ(t, u) := ue
 θs ds
K(t, u) := e−κ(t−u)
−2κ(t−u)
Γ(t, u) := 21 ν 2 1 − e 2κ

.


We also abbreviate

Θj := Θ(τj , τj−1 ) , Kj := K(τj , τj−1 ) and Γj := Γ(τj , τj−1 ) .

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Iteration
The aim is to make sure with out choice of (Cj )j=1,...,N that
h P i
Q − j:j≤` dj
!
E e h P i
Q − j:j≤` (Ej yτj +Cj )
1= P = E e .
e− j:j≤` Dj
Consider the formula
h P i
c` (p) := log EQ e− j:j<` (Ej yτj +Cj )−(E` +p)yτ`

which obviously yields with C` := c` (0) the desired correction terms. We will
derive these functions iteratively: we start with ` = 1. Using (10) yields readily

c1 (p) = −(E1 + p)K1 y0 − (E1 + p)Θ1 + (E1 + p)2 Γ1 .

The next step is ` > 1 to determine c` (p) assuming we know cj (q) and there-
fore Cj for j < `.
h P i
ec` (p) = EQ e− j:j<` (Ej yτj +Cj )−(E` +p)yτ`
h P h ii
= EQ e− j:j<` (Ej yτj +Cj ) EQτ`−1 e
−(E` +p)yτ`

h P 2
i
= EQ e− j:j<` (Ej yτj +Cj ) e−(E` +p)K` yτ`−1 −(E` +p)Θ` +(E` +p) Γ`
h P i 2
= EQ e− j:j<`−1 (Ej yτj +Cj )−(E`−1 +(E` +p)K` )yτ`−1 e−(E` +p)Θ` +(E` +p) Γ` −C`−1
2
= e−(E` +p)Θ` +(E` +p) Γ` +c`−1 ((E` +p)K` )−C`−1

which means that

c` (p) = −(E` + p)Θ` + (E` + p)2 Γ` + c`−1 ((E` + p)K` ) − C`−1 (11)

is well-defined.

A.3 Future Forwards

A very similar calculation as the above allows us to compute the future forwards
of the model,
Ft (T ) := Et [ ST ] .
We sketch the idea here: let n : τn ≤ T < τn+1 and k : τk−1 ≤ t < τk . First of
all,
RT Q h − Pj:k≤j≤n (Ej yτj +Cj +Dj ) i
Ft (T ) = St E e .
Rt t
The last term can be handled with the same method as above: define for ` : ` ≤ n
h P i
− j:k≤j<` Ej yτj −(E` +p)yτ`
c` (t; p) := EQ
t e .

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The first term we need to know is

ck (t; p) := −(Ek + p)K(t, τk )yt − (Ek + p)Θ(t, τk ) + (Ek + p)2 Γ(t, τk ) .

and all further terms have the same structure as (11), i.e.

c` (t; p) = −(E` + p)Θ` + (E` + p)2 Γ` + c`−1 (t; (E` + p)K` ) .

The forward is then given as

RT cn (t;0)−Pj:k≤j≤n Cj +Dj RT At (T )yt +Bt (T )
Ft (T ) = St e ≡ St e (12)
Rt Rt

for some A and B (note that cn (t; 0) is a function of yt ).

A.4 Fitting to Equity Vanillas

Assume we are given a term structure of reference maturities 0 < T1 < T2 < · · ·
for which we are given Black & Scholes-implied volatilities (Σk )k on the stock
price. We want to bootstrap a piecewise linear equity forward volatility term
structure σ ≡ (σk )k which is constant over the intervals [Tk−1 , Tk ].
To do so, we iteratively solve the following quadratic equation in σk :

Var(Tk ) − Var(Tk−1 ) = σk2 (Tk − Tk−1 )

X
−2σk · ρν e−κτi Ei Oki
i:Tk−1 <τi ≤Tk
( )
X X
+ Ei Ei − ρνe−κτi σr Kr
i:Tk−1 <τi ≤Tk r:r<i

with
eκTr − eκTr−1 eκτi − eκTk−1 X 1 − e−2κτj
Kr := , Oki := , Ei := Ej ν 2 .
κ κ 2κ
j:j≤i

References
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The World of Equity Derivatives - The Essential Toolbox for Investores,
Eurex, September 2008,
http://www.eurexchange.com/download/documents/publications/
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[2] B.Baldwin:
“Dividend Derivatives: Introduction of Options on EURO STOXX50 Index
Dividend Futures”, eurex circular 082/10, May 2010,
hhttp://www.eurexchange.com/download/documents/circulars/cf0822010e.pdf

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[3] A.Bermudez, H.Buehler, A.Ferraris, C.Jordinson, A.Lamnouar,
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[11] D.Wood:
“Uncertain Dividends”, Risk Magazine, Oct 2007
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“Options on DIVD and DVS Indexes”, CBOE Website, May 2010,
http://www.cboe.com/micro/dvs/introduction.aspx and
http://www.cboe.com/micro/dvs/DIVDFAQ.pdf

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