A:

A derivative is a financial instrument that derives its value from a stock or a bond. There are several derivatives that pay dividends, allowing an investor to enjoy the benefits of owning a stock while avoiding the cash outlay and risk associated with purchasing the stock as well as avoiding the tax on the dividend.

A dividend swap is a derivative in which the counterparties exchange a set of future cash flows at set dates in the future. The floating leg payer pays the future dividend flow on a stock, basket of stocks or an index, and the fixed leg payer pays a predetermined fixed amount at regular intervals.

In a total return equity swap, one counterparty pays either a predetermined fixed amount at regular intervals or a floating amount based on an index, such as LIBOR. The other counterparty makes payments based on the total return of the underlying stock, basket of stocks or index. This return includes capital gains and dividends.

A dividend future is an exchange-traded derivative in which the investor bets on the future dividends paid by a stock, basket of stocks or index. For example, assume that a company currently pays a quarterly dividend of 10 cents per share. If an investor buys a dividend future, the settlement price of the future would be 40 cents ($0.10 X 4). The return depends on the difference between the price when the investor bought or sold the future and the settlement price. So, if the investor bought the future at 30 cents, his profit would be 10 cents.

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