Current Research on Ex-Dividend Day Price Behavior J. B. Chay ( 최종범 ) School of Business Sung Kyun Kwan University

Ex-Dividend Day Price Behavior Elton and Gruber (1970) Sell before the ex-day: (P cum – P basis )(1 – T c ) Sell on the ex-day: (P ex – P basis )(1 – T c ) + D(1 – T o ) To be indifferent as to timing: (P cum – P ex )(1 – T c ) = D(1 – T o )

Ex-Day Drop-Off Ratio (DOR) T d > T c : DOR < 1

Ex-Day Return (RET) T d > T c :RET > 0 DOR < 1

Evidence The drop-off ratio (DOR) has been consistently below one for decades. Ex-dividend day return (RET) has been consistently positive for decades.

Tax Effects DOR=0.777 Low dividend yield  Low DOR Elton and Gruber (1970) Barclay (1987) Before the introduction of the income tax in the U.S., ex-day price drops were on average equal to the dividend (DOR=1) No correlation between DOR and Div Yield

Short-Term Arbitrageurs Short-term arbitrageurs engage in ex-day trades so that the ex-day drop in price will approach the size of the dividend. If transaction costs were zero, the ex-day price drop should equal the dividend. Kalay (1982, 1984)

Short-Term Arbitrageurs If short-term trading is important, then ex-day price drop will reflect transaction costs of arbitrageurs rather than the relative tax preferences of the long-term investors.

Microstructure Argument: Discreteness in Prices Ex-dividend day price drop less than the dividend is due to discreteness in prices rather than taxes. Due to discreteness in prices, the ex-day price should fall by an amount equal to or smaller than the dividend. Bali and Hite (1998)

Microstructure Argument: Nuisance in Collecting Dividends Frank and Jagannathan (1998) Collecting and reinvesting dividends is bothersome for individual investors but not for market makers. Thus market makers tend to buy before a stock goes ex-dividend and then to sell on the ex-day.

Microstructure Argument: Nuisance in Collecting Dividends Most transactions occur at the ask price before the stock goes ex-dividend and at the bid price after it goes ex-dividend. In the absence of taxes this means that the fall in price on the ex-day will be less than the dividend.

Where cash dividends are tax-advantaged relative to capital gains and there are barriers to short-term arbitrage, DOR>1 RET<0 Green and Rydqvist (1999) Recent Evidence on Tax effects

Ex-day returns (RET) increase in the 1/16 th and decimal pricing eras, relative to the 1/8 th era. RET increase in conjunction with a May 1977 reduction in the capital gains tax rate. Graham, Michaely and Roberts (2002)

Application: Effective Tax Rate on Capital Gains The option to time (or delay) the realization of capital gains is valuable because capital gains are taxed in the U.S. only on realization. Thus, nominal and effective rates of capital gains tax may differ.

Chay, Choi, and Pontiff (2003) Using the ex-dividend day experiments, we try to determine the empirical importance of the tax-timing option.

Capital gains are tax advantaged, even if they are taxed at the same rate as ordinary income.  Taxed gains are reduced by capital losses.  Effective Taxes reduced by delaying gains and realizing losses early [Constantinides (1983)].  Investors may respond to changes and anticipated changes in tax codes.  Investors can realize gains when their personal rate is lower.

Capital Gains Distributions Novel type of dividend Capital Gains distributions are dividends that are taxed as realized capital gains. By focusing on ex-dividend returns, this feature allows us to compare how realized capital gains are valued by the market relative to unrealized gains (price changes).

Main Findings After the 1986 Tax Reform Act, DOR=0.93 $1 of realized capital gains = 93 cents of unrealized gains 15% (28%) of nominal tax rate on realized capital gains = 8.6% (22.6%) of effective tax rate on unrealized capital gains

Main Findings Before the 1986 Tax Reform Act, Differences in long-term and short-term capital gain rates created tax arbitrage. Capital gain distributions were more valuable than price changes in the underlying security.