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It is for this reason that decrement indices were developed a few years ago. issuers were able to offer more favourable conditions on a structural level since the dividend risk was eliminated. Nevertheless, this concept has its price as well. A look at the special construction of decrement indices shows the trade-offs and their risks.

A decrement is an overlay that is applied to securities indices. A decrement index is constructed by subtracting a pre-defined dividend (also referred to as a synthetic dividend) from the return index on a daily basis. As the total return is divided into the price return and the realised dividend, there is a fixed relationship between these two elements.

Fixed percentage deduction versus fixed point deduction

Decrement indices use two different methods to deduct the pre-defined dividend: fixed percentage deduction or fixed point deduction. In the first method, a fixed percentage of the return is deducted daily, while in the latter method, fixed index points are deducted from the index level.

The logic of the fixed percentage method is that the dividend yield remains stable over the long term. Dividend discounts on indices with fixed percentage decrements therefore frequently correspond to long-term historical averages of dividend yields.

On the other hand, a fixed point deduction captures the constancy of dividend amounts over the short term, as companies tend to have a stable dividend policy relative to their earnings. In the case of fixed point deductions, the effective percentage deduction at the index base date, which is computed by dividing fixed points by the initial index level, is usually established to match the dividend yield realised most recently.

In times of stable markets, both methods frequently yield close results, but they may also show significant differences depending on whether the underlying index level moves more or less. For indices with a fixed percentage discount, in particular, the percentage deduction from the total return remains constant. For indices with a fixed point discount, the deduction will be variable depending on how the market is moving.

Conclusion

The decrement strategy is an index innovation aimed at addressing specific challenges that are faced by structured products – specifically in a low interest rate environment and in view of the need to hedge dividend risk.