Frictions and Tax-Motivated Hedging: An Empirical Exploration of Publicly-Traded Exchangeable Securities
Posted: 19 Aug 2003
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Frictions and Tax-Motivated Hedging: An Empirical Exploration of Publicly-Traded Exchangeable Securities
Frictions and Tax-Motivated Hedging: An Empirical Exploration of Publicly-Traded Exchangeable Securities
Abstract
As financial engineering becomes more sophisticated, taxing income from capital becomes increasingly difficult. We offer the first empirical study of a high profile strategy known as "tax-free hedging," which offers economic benefits of a sale without triggering tax. We explore nontax costs that taxpayers face when hedging by issuing so-called "DECS," "PHONES," and other publicly-traded exchangeable securities. Focusing on 61 transactions between 1993 and 2001, we shed light on why taxpayers might prefer to hedge through private "over-the-counter" transactions: An offering of exchangeable securities is announced in advance and implemented all at once, triggering an almost 5 percent decline in the underlying stock price before the hedge is implemented.
Keywords: DECS, frictions, constructive sales, hedging, capital gains
JEL Classification: G30, G14, H25
Suggested Citation: Suggested Citation