Variable
InternationalequitiesShares
8.30±17.00
Screen-based quote system withautomated execution system. Thereare 2 systems in Nasdaq: the SmallOrder Execution System (SOES), forautomatic execution of small orders(up to 1,000 shares), and SelectNet fornegotiated transactions and electronicexecutions.
National SecuritiesClearing Corporation(NSCC) for allsecurities other thanoptions
9.30±16.15
DeutscheBoÈrseÐFrankfurt SE
NASD
Clearing andSettlementOrganization
9.30±16.00
SettlementCycleT 3
CSD
Taxes onTransactions
Depository TrustCompany (DTC)
None
T 3T 3T 3
Ministry ofEconomics of theState of Hesse
Deutsche BoÈrseClearing AG
T 2
Deutsche BoÈrseClearing AG
None
Her Majesty'sTreasury(CompetentAuthority) FinancialServices Authority
CREST
T 5
CREST
0.5%
Euroclear/Cedel/localsystemsNational SecuritiesClearing Corporation(NSCC) andDepository TrustCompany (DTC)
As homemarketT 3
Depository TrustCompany (DTC)
No stamp duty andtransfer taxes ontransactions
Securities andExchangeCommission (SEC)
Taxes on Dividends, InterestsUS Citizens and Residents:Dividends, interest, and short-term(assets held not more than 18months) capital gains are taxed asordinary income (39.6% marginalrate). Long-term capital gains aretaxed at a 20% marginal rate. Stateand local authorities may imposeadditional income taxes.Non-Resident AliensDividend and interest income issubject to a 30% withholding tax.This tax may be reduced oreliminated if the nonresident isentitled to the bene®t of a tax treaty.Capital gains generally are notsubject to income tax.Residents: Depending on totalannual income. Max. 53%.NonResidents: Dividends:depending on double taxationtreaties, average: 15% with possibleclaim of refund of 10%.Dependent on taxpayer attaxpayer's marginal rate of taxation
15%±28% (treated as ordinaryincome)
(continued)
TABLE 2-2 (continued)
Exchange
Types ofSecuritiesTraded
New York
StocksBondsWarrnts
Paris
EquitiesBonds
Tokyo
SharesStock investmenttrust certi®cates
Trading System/Derivatives Market
TradingHours
SupervisoryBody
Clearing andSettlementOrganization
Floor Trading(SuperDot order routing and reportingsystem)Auction market with specialistsNSC (Nouveau SysteÁme de Cotation)
9.30±16.00
Securities andExchangeCommission (SEC)
National SecuritiesClearing Corporation(NSCC)
T 3
Depository TrustCompany (DTC)
None
15%±28% (treated as ordinaryincome)
10.00±17.00
CMF/COB
Clearing-house: SBFBourse de ParisSettlement: SICOVAM
T  3 andmonthlysettlementbasis
SICOVAM
Dividends and interest are declaredas revenue and taxed accordingly.There is a tax credit on dividends(``avoir ®scal'')
9.00±11.00 and12.30±15.00
Ministry of Finance
TSE, Japan SecuritiesClearing Corp. (JSCC)
T 3
Japan SecuritiesDepository Center(JASDEC)
Capital gains above50,000 taxed at 26%Stamp duty onFrench securities forFrench individualinvestors0.10%
Floor and screen-based trading withCORES (Computer-Assisted OrderRouting and Execution System)
(Source: Compiled by author from FIBV data.)
SettlementCycle
CSD
Taxes onTransactions
Taxes on Dividends, Interests
Dividends: Residents: Aggregate orseparate (35%) Nonresident: 20%
69
70
THEORY AND TOOLS
. A clearinghouse receives shortly afterÐusually the next dayÐan
electronic download of these transactions.6 It allocates these tradesamong its members, and it informs them of the transactions itknows.. On settlement day, stocks are received and delivered for payment,and the corresponding entries are recorded in the book of anational depository trust.
Even if each market has its own settlement rule and its particularentities, the value chain is virtually identical. It is imposed by thevolume of transactions commonly handled by exchanges around theworld and the demand for a safe and reliable settlement environment. Indeed, it is important to emphasize that this apparently complex structure has been designed to reduce a major settlementconcern, the risk that a counterpart receives securities and fails topay for them because it defaults. Institutions with clearly de®nedroles and a close integration with the Fedwire systemÐwhich handles most monetary ¯ows in the United StatesÐintervene to ensurethat a delivery does not occur without a corresponding payment.Even with the level of effort applied into the design of an ef®cientsystem, the credit risk inherent in the settlement process has notentirely disappeared and remains a real concern even in theUnited States.7
Date Convention
We will refer to the trade date (TD) or operation date (OD) as the date onwhich the transaction is actually executed on the exchange, and to valuedate (VD) or settlement date (SD) as the date on which the shares arephysically received or delivered against full payment. From a riskpoint of view, market exposure appears on the operation date, notthe settlement date.86
In some countries a single clearinghouse clears all the trades at a national level. Inother countries several distinct small clearinghouses exist and manage the clearingprocess through a set of electronic automated links.7Under some circumstances, a fail to deliver may occur even with large names. Undertight borrowing conditions, for example, short sellers of a given security may bepunctually unable to ful®ll their obligation to deliver. Most day-to-day failures areisolated and corrected rapidly and therefore inconsequential.8Naturally, from a ®nancing perspective, interests on the money received or paid startor stop accruing from the settlement date.
CHAPTER 2 STOCKS
71
In the United States, the standard value date is three business opendays: VD  OD + 3.9 This holds for all U.S. stocks, regardless of theexchange they are listed on. The exact de®nition of business day is a dayon which U.S. banks are opened for businessÐin other words, a day onwhich monetary transactions can be settled. Some days are bankingholidays but not exchange holidays; no stock transaction is settled eventhough the exchange is open.In the United Kingdom, stocks settle on OD + 5; in Germany,OD + 2; in Japan, OD + 3. The most interesting example of uncommon settlement is France, which uses a liquidation process for themain section of the Paris Stock Exchange, known as ReÁglementMensuel (monthly settlement). Transactions are physically settledonly on the last open day of each month. Six days before, a generalliquidation process is run; the total volume of outstanding buys ismatched against the total volume of outstanding sells, stock bystock. Each participant has announced prior to the matching his orher intention to settle his or her position, or, on the contrary, tocarry it over into the following month. Accordingly, the liquidationshows an outstanding balance of shares unsettled; an excess of sellers who decide not to deliver will create a borrowing position on thesecurity, and reciprocally. Eventually, each participant with a position carried over receives or is liable for the cost of carry, accordingto the settlement unbalance.10 To ensure a minimum coverage forthe risk outstanding and not settled, the exchange requires a 20percent deposit on all open positions11 to be paid on the operationdate. This process is similar to the deposit requirement of a futures
9
The United States is currently moving toward a settlement at OD + 1, mandated bythe Securities and Exchange Commission for 2002.10The cost of carry can be of two types: If a buying position is unsettled and a longbalance of stocks appears as a result of the liquidation, there is a de®cit of cash on themarket. Many sellers have claimed their proceeds, and too few buyers are paying fortheir purchases. Accordingly, the necessary injection of money is charged to thebuyers, and as a result, their cost of carry is equivalent to a ®nancing cost fromthis liquidation to the next. The second type of cost is the opposite, and it is lessfrequent: Sellers are unable to deliver the sharesÐbecause there are too many shortselling positions, for example. In that case, they are charged, in essence, a borrowingfee.11The liquidation offers ``®nancing-free trading,'' to a certain extent. An investor settling his or her trade at the ®rst liquidation after his or her transaction will save the®nancing cost on 80 percent of his or her position from trade date to liquidation date.However, if he or she carries over, he or she ends up paying a charge equivalent to afull month ®nancing until the next liquidation.
72
THEORY AND TOOLS
contract. It also implies margin calls when mark-to-market lossesexceed the initial deposit.12
CROSS-EXCHANGE LISTINGIntroduction
Considering the ongoing globalization in the markets for goods andservices, it is no surprise that a parallel globalization is occurring in themarkets for capital. When corporations that are traditionally established in delimited geographical areas expand to a global scale, it isa legitimate concern for them to reconsider the localization of theirinvestor base. Having listed decades or years earlier their shares intheir home market, they face the opportunity to list those shares onforeign exchanges, with distinct bene®ts and costs.Cross listing is important from an arbitrageur perspective becauseit is a very simple and straightforward opportunity, as we mentionedearlier. In addition, it is more and more frequent, therefore it is ofinterest to our overall target. The following discussion focuses primarily on the rationale for cross listing and details the most importantinnovation: depository receipts.
International Cross ListingRationaleThe rationale for a cross-listing initiative can be multifaceted. The mostbasic motivation is to raise capital from international investors to establish a presence in capital markets untapped before.13 If raising capital isnot needed, listing the stock might attract a wider shareholder base and
12
At the time of writing, the ReÁglement Mensuel is still in existence, but its days arenumbered. Indeed, the French Stock Exchange has announced that all stocks willfollow a regular settlement cycle OD + 3 from September 25, 2000. Individual investors will still have the option to postpone settlement to the end of the month like amonthly settlement, but this service becomes a convenience feature provided bybrokers, at a cost.13In the case of non-U.S. companies listing their shares in the United States, evidencesuggests that the overall cost of equity goes down subsequent to the listing by morethan 1 percent.
CHAPTER 2 STOCKS
73
diversify control of the company. The reasons for doing that may bediverse, but undoubtedly the growing interrelation of world marketscall for a reexamination of corporate control beyond geographical borders.14 In addition, attracting new investors may improve the overallliquidity of the stock.15Therefore, in a context where the need exists, numerous solutionshave been proposed to address it. The simplest form of cross listing, forexample, is a direct listing on a domestic exchange of a foreign stock.The company applies for listing directly to the exchange, and it mustsatisfy all the conditions set forth in the listing agreement,16 in additionto paying aÐusually signi®cantÐlisting fee. Numerous exchangeshave indeed developed ``foreign sections'' in their effort to attract foreign corporations. However, this process can be long and expensive,and one alternative has been proposed and been very successful overthe years: depository receipts.Depository ReceiptsDepository receipts were invented by JP Morgan in the late 1920s.Instead of having a ®rm apply directly for listing, an American institutionÐusually a bankÐholds some of its shares and issues a depositaryreceipt in the United States against them.17 For example, in a 1-to-1ADR, each depository receipt corresponds to one share of the company. The receipts are then listed in the United States by the issuinginstitution, and they are traded as if they were actual shares of the
14
For a complete discussion of this phenomenon, see Andrew Karolyi, ``Why DoCompanies List Share Abroad? A Survey of the Evidence and Its ManagerialImplications,'' Financial Markets, Institutions and Instruments, The NYU SalomonCenter for Research in Financial Institutions and Markets, 1998.15A subsequent interesting question is whether the overall liquidity aggregates in oneparticular marketplace. See Melek Pulatkonak and George So®anos, ``TheDistribution of Global Trading in NYSE-Listed Non-US Stocks,'' NYSE WorkingPaper 99-03, 1999, for a more complete examination of this issue.16Indeed, it must also satisfy the disclosure and accounting requirements in the targeted country. This particular condition is especially constraining for a listing in theUnited States, which probably has the most stringent accounting standards.17Depository receipts can be American (ADR) when the recipient market is the UnitedStates or global (GDR). Originally this structure was used by companies looking tolist their stock in the United States; therefore, ADRs has become the generic term todescribe these papers, and we will follow this convention here.ADRs can be created and redeemed at will by investors, like open-end funds. Themanagement of these operations is performed by the issuing institution for a fee.
74
THEORY AND TOOLS
foreign company. The whole process is faster and cheaper than a directlisting.18 The price of the ADR is directly established by the conversionin dollars of the stock price traded on the primary exchange of thecompany.19ADRs can be sponsored or unsponsored by the foreign company.The main difference between these two statuses is that the depositoryof a sponsored ADR is assured of an exclusive agreement and a favorable cost allocation for the expenses related to the daily operations ofthe ADR. In general, sponsored ADRs tend to offer more transparencyto shareholders in terms of corporate activityÐboard and shareholdermeetings and voting rightsÐbecause the corporation is explicitly backing the effort to develop a presence in the market where ADRs arelisted. ADRs can also be of several types depending on the exchangeon which they are listed and the depth of the registration process theissuing corporation has opted for. For example, for an ADR issued toraise capital, the registration process with the Securities and ExchangeCommission in the United States is much more stringent than for areceipt listed for trading purposes only.ADRs have become particularly popular for ®rms operating inemerging markets because they give access to a shareholder base ina stronger and more mature environment, typically the UnitedStates. ADRs from South America and Southeast Asia accountedfor a third of the 300 listed ADRs on the NYSE, Nasdaq, andAMEX in 1997.20The Settlement ProblemGenerally speaking, a critical dif®culty in following ADRs or crosslisted stocks is related to the settlement of the different transactions.The date of delivery of the certi®cates may be different between twomarketplaces, and more importantly the currency used to settle thetrades may also be different. In addition, clearing institutions mightalso be distinct, possibly creating a nonstandard transfer of ownershipand delaying settlement beyond the normal period.18
Notably, the underlying corporation does not have to appoint a custodian for itsshares in the market where it wants to be listed. The institution issuing the receiptsundertakes this function as part of the overall ADR arrangement.19Because of this particular feature, ADRs can be considered derivative securities for allpractical purposes.20Amar Gande, ``American Depository Receipts: Overview and Literature Review,''Financial Markets, Institutions and Instruments, The NYU Salomon Center forResearch in Financial Institutions and Markets, 1997.
CHAPTER 2 STOCKS
75
A mismatch in settlement dates is a minor concern and will createonly a ®nancing residual. For example if a purchase is effected on amarket where the settlement cycle is long, the amount of money to bedelivered will remain longer on the account generating additionalinterests. This ®nancing residual can be positive or negative dependingon the settlement conventions on each leg, on the interest rate differential and naturally on the direction of the trade.The issue of the currency is slightly trickier. Consider the stockXYZ of a European company listed somewhere in EuropeÐineurosÐand in the United StatesÐin dollars. Assume that the exchangerate is 1 today, that is, $1  1, and the price is P  $100  100. Forsimplicity, both markets settle with the same cycle.If an American investor buys the stock in the United States, he orshe delivers $100 in exchange for the certi®cates. The same investorwants to sell the certi®cates a few days later, and at that time theEuropean price is 102, the exchange rate 1.1 ($1  1.1). The pricein the United States is therefore P  $92.73 ( 102=1:1) because anyother price would create an arbitrage opportunity.The resulting situation is somewhat surprising because the stockhas appreciated in Europe, from 100 to 102 and yet the investorwould realize a loss, from $100 to $92.73 if he or she sold his or hershare. Maybe the right answer is to sell it in Europe, for 102.However, this transaction would not solve the problem because theinvestor would receive 102 on settlement day and would have tomanage a foreign exchange position from then on. If he or shewanted to get rid of it, he or she could exchange euros for dollarsat a rate of 1.1, and then end up with $92.73 anyway. This simpleexample shows clearly that the investor carries an exposure to the$/ rate, despite the fact that he or she never intended to. The stockappreciated by 2 percent, but the euro depreciated by 10 percent, andbecause the company is European, the U.S. price adjusted downwardwith the depreciation of the currency.In this example, the European price is driven by pure marketforces whereas the U.S. price is simply a conversion and is affectedprimarily by the exchange rate. The reason for this is that we implicitly assumed Europe to be the primary exchange, that is, the mainsource of liquidity. If the same company had been listed and hadbeen doing business primarily in the United States, the price therewould have been subject to market forces whereas the European pricewould have followed the exchange rate. Incidentally, the same foreign exchange risk exists with respect to dividends if they aredeclared and paid in a foreign currency.
76
THEORY AND TOOLS
DIVIDENDSDe®nitions and Conventions
A dividend is a distribution of accumulated pro®ts from a corporationto its shareholders. It can take two basic forms: a cash payment or adistribution of new shares, both being rarely combined.21 We willexamine here only cash dividends because a share dividend can alsobe considered a variable cash payment.There are four important dates in the process of dividend payment:. Announcement day: The company, as decided by its executive board,
announces when the dividend will be paid and what its amountwill be.. Last trading day: This is the last day on which buying the stockentitles the holder to claim the dividend.. Ex-date: The stock trades ``ex''Ðthat is, without dividend rights.22. Payment date: Payment is effected by the trust bank of the payingcorporation.
In the United States, dividend distribution follows a quarterly pattern, and companies usually have a clear policy about disclosing information as early as possible. The actual payment takes place only a fewdays after the ex-date. By contrast, in Japan the amount of dividend is,before payment, a pure estimation.23 Companies generally do not disclose any information before the board meeting that actually ®xes theamount, and this meeting is usually called between three and fourmonths after the ex-date. Payment itself occurs a few days after. InEurope, most companies disclose their dividends in advance as inthe United States, although distributions are made yearly in general.For medium- or long-term projections, even for companies thathave established a track record of early and consistent disclosure, dividends cannot be much more than an educated guess, both in terms ofthe ex-date and the amount.24 A very interesting version of this pro-
21
There are many other ways for corporations to channel wealth to their shareholders,share buybacks being probably the most common example.22The ex-date is logically the next business day after the last trading date.23Note that this situation creates a signi®cant risk. The stock goes ex by an estimateddividend amount, and all trading parameters, like the fair value of a futures, arecalibrated on this estimation. If the actual payment is different, the difference betweenthe two generates a pro®t or a loss.24In that context ``medium'' or ``long term'' is anything beyond six months.
CHAPTER 2 STOCKS
77
blem appears with JP Morgan, for example. The company distributesquarterly dividends with an ex-date around the third Friday of March,June, September, and December. As it turns out, these are expirationdates for the S&P 500 as well as for Dow Jones futuresÐand otherderivatives such as options. Depending on when the stock actuallygoes ex, the fair value of each index can be signi®cantly affected. Thecompany is usually not in a position to con®rm the exact ex-date morethan three months in advance, resulting in systematic uncertainties.No particular registration is necessary to receive payment from adividend distribution: The depository trust automatically credits itsmembers' accounts according to their balance when payment ismade from the company's trust bank. In some rare cases, however,stocks are still materialized, and the presentation of the actual stockcerti®cates to the trust bank is required.25
Taxation
Because dividends are cash payments, an additional problem lies intheir taxation. In general, tax optimization is beyond the scope of atrader's responsibilities, and it is performed at a much higher level. Fordividends, however, the issue is critical and needs to be consideredcarefully.Dividends are generally not tax free and are therefore effectivelysubject to a double taxation. Corporations are taxed a ®rst time on theirearnings through corporate tax, and dividends, distributed off netincome, are after-tax money re-taxed a second time at the recipient'slevel. Fiscal authorities throughout the world are well aware of thisissue and have decided individually to ignore or correct it.In the United States, for example, dividends are taxed as regularincome, for corporations as well as individuals. In the vast majority ofcases, investors cannot claim any tax break or credit to offset the second layer of taxation, making dividend distribution a very tax ineffective way of redistributing corporate wealth.26 Under certain25
This is the case in Japan for a handful of securities. In order for the government tomonitor the pool of shareholders in industries considered sensitive, some companiesrequire shareholders to register physical certi®cates. Investors must withdraw thesepapers from the depository trust and make themselves known. These companies aremostly information networks such as Nippon Television and air carriers such as AllNippon Airways and Japan Airlines.26A notable exception to this rule is the case of a corporation holding a majority equityinterestÐabove 80 percentÐin a subsidiary. In this situation, the dividend is receivedtax-free.
78
THEORY AND TOOLS
circumstances, however, dividends are shielded from taxation becauseof other deductionsÐinterest expense, for example. Japan has a different taxation rule, but the result is essentially the same. A ®xed withholding tax is applied to all dividend payments, and no credit or taxbreak is allowed to offset it.In Europe, the issue of double taxation is considered from a morepositive angle by ®scal authorities. Dividends are recognized as regularincome and taxed accordingly. However, corporations as well as individuals are allowed to deduct from their payable taxes an exceptionalcreditÐcalled a tax rebateÐequal to the amount of taxes ``overpaid''through the double taxation.For example, consider a French corporation receiving a dividend of15. This income will be taxed at the corporate tax rate, say, 331/3percent, generating a tax liability of 5 and net income of 10.According to the ®scal law, the corporation is allowed to recognize a50 percent tax credit, applicable to net dividends. Therefore, it willdeduct 50 percent of 10Ðthat is, 5Ðfrom its tax bill, in effect eliminating the original 5 tax liability. This mechanism is designed tomake dividends effectively tax free and remove the second layer oftaxation.27It is important to realize, however, that there is no reimbursementfrom ®scal authorities, only a deduction from existing taxes.28Therefore:. It can be claimed only by an entity subject to corporate taxes in the
country, such as a domestic corporation, a broker-dealer, or investment fund.. By nature, it is deductible from a positive amount onlyÐthat is, theentity must show a pro®t.. For the exact same reason, it is capped by the total amount of taxesreported.
The tax rebate is a source of many arbitrage opportunities, as we willsee shortly. Its days are numbered, however, because governmentsthroughout Europe are slowly but surely taking it apart. In theUnited Kingdom, for example, the Labor government had announced27
The reality is naturally more complex than that. The French corporate tax rate hasbeen revised several times over the years, and is not at 331/3 percent anymore.Individuals are also entitled to the full bene®t of tax rebates, regardless of theirmarginal tax rate.28Furthermore, restrictions apply: For example, in Germany this rebate cannot beclaimed against an index arbitrage position.
CHAPTER 2 STOCKS
79
during its campaign a major ®scal reform, and it effectively launchedone once in power. The tax rebate was purely and simply abolished,except for some institutionsÐtypically pension funds. In Germany andFrance, the trend is toward more restrictions and lower credit allowance, and it would not be surprising to see the rebate evaporate progressively.
International versus Domestic Accounts
In fact, the issue of dividend taxation is even more complex because weimplicitly focused so far on domestic corporations' paying domesticshareholders, which is somewhat restrictive. Nonresident investorsalso receive payments and face a complex situation because they arepotentially liable for taxes in their home countries in addition to beingtaxable in the country of the paying corporation.29 To avoid a possibledouble taxation, cross-border taxation issues have been negotiated overthe years between states and are now often governed by bilateraltreaties.Most of the time, treaties call for mutual recognition and effectivelycreate a single taxation regime. However, the practical realization ofthis regime is not necessarily straightforward. In many cases, dividends are taxed by the country of the paying corporation, and therecipient is allowed to recognize a corresponding tax credit with regardto domestic taxes. The process does not necessarily ensure that all taxescan be recovered, a point that is essentially dependent on the depth ofthe mutual recognition agreement.Therefore, different players located in different countries will nothave the same dividend expectations on the same security. For example, a domestic entity may very well bene®t from a tax rebate while anonresident does not, or only partially, depending on the prevalentbilateral agreement with its domestic ®scal authorities. This situationintroduces a bias between participants of the same market and pavesthe way for ®scal arbitrage.Assume, for example, that a nonresident stockholder is ready tolend his or her portfolio to a domestic participant, in a country wheredomestic investors receive dividends essentially tax free, while nonresidents do not. If these shares appear on the book of the domestic entitywhen dividends are paid, and if it has taxable income, chances are it29
Incidentally, a similar problem exists for foreign companies listed on domesticexchanges, or for ADRs. Dividends from ADR stocks held by domestic investorsare usually taxed differently from domestic corporations' dividends.
80
THEORY AND TOOLS
will be in a position to claim the tax rebate, on a position that is onlytemporarily borrowed. At this point it could very well return the stocksand pay the original owner dividends net of taxes because this is whathe or she would have received anyway due to its tax status. The operation is risk free for the domestic player, and it results in a pro®t equal tothe amount of the tax rebate. Naturally, in practice, all is not so easybecause the original lender would probably claim part of this rebate forthe reason that he or she originally permitted the operation by lendinghis or her portfolio. The domestic entity will ``kick back'' part of therebate, and this kickback is usually referred to as tax rebate pricing. Atax rebate priced at 20 percent means that the borrower of a securitywould return 20 percent of the rebate to the lender.30 The rebate pricingis a market variable: Intuitively there is no reason why it should differfrom 50 percent, but in practice, it is in¯uenced, for example, by thesupply of stocks to borrow and the competition between potentialborrowers and lenders.This arbitrage effectively transforms the tax rebate into a tradedcommodity. To bene®t from it, however, participants must have apro®table legal representation within countries with a tax-rebate policy, which means essentially Europe. In the context of the professionaltrading we have in mind, this particular requirement illustrates the``competitive convergence'' we mentioned very early on. If trading asa nonresident leads to opportunity losses or lack of competitiveness,major players have the ®nancial strength to take the necessary stepsand open a subsidiary wherever it is needed. Eventually, all majormarket participants end up with a similar structure, a move that effectively eliminates obstacles but does not create any additional advantage for any of them.
Market Rebate
If the tax rebate is a traded commodity, it should be observable directlyin the marketplace. Indeed it is, in two ways. On one side, borrowingand lending of securities are transacted under terms that have toinclude a rebate pricing because they constitute the primary vehicle30
A little bit of illustrative arithmetic: If the tax rate is 30 percent, and the rebate pricedat 20 percent, net dividends are 70 percent of gross, and the lender of a securitywould claim 76 percent of gross (70 percent plus 20 percent of 30 percent). By extension, the rebate is sometimes said to trade at 76 percent. Note that the repartition ofpro®ts is asymmetric: The nonresident investor receives an additional 6 percent ofgross dividends in the arbitrage, while the domestic arbitrageur receives 30 percentand nets 24 percent after paying the 6 percent kickback.
CHAPTER 2 STOCKS
81
through which this rebate actually changes hands. On the other side,the rebate in¯uences the total amount of dividends receivable from agiven security and after aggregation, directly appears in the calculationof the fair value of the future.31 Therefore, market participants have astraightforward access to the level of market rebate by looking at borrowing and lending transactions, or at the activity of index arbitrageurs.32
The Importance of Careful Dividend Management
Most indices throughout the world yield between 2 percent and 4percent in dividends, even less in some instances. Even if we considerdividend to be taxed at 20 percent for example, the possible tax loss isfairly low, between 0.40 percent and 0.80 percent. For most investors,including fund managers, a