The impact of dividend-capturing arbitrage on the market value of imputation credits

Abstract

A growing body of literature has attempted to determine the market value of a dollar of imputation credits (theta). By observing the market prices of securities around the ex-dividend date, these studies have consistently estimated that theta is significant and positive. Another subset of literature however, has consistently found that imputation credits do not affect a firm’s cost of capital, and are not capitalised into stock prices. These conflicting results provide a puzzle within the literature. We theorise, and then empirically show, that the values of theta observed in prices around the ex-dividend date are inflated upwards by the activity of short-term traders and arbitrageurs. Once we exclude their activity from our analysis, we use a considerable sample of 200,000 observations, to show that the market value of imputation credits is insignificantly different from zero. These results provide us with evidence that, consistent with the cost-of-capital literature, long-term providers of equity place no value on imputation credits. Our results therefore act to bridge the gap between these two areas of research, and solve the puzzle that exists within the literature. The fact that these imputation credits are priced into futures contracts at a value far below their face value also raises the question: are domestic investors able to exploit this low value by simultaneously entering into two opposing positions – a long position in the company’s stock, and a short position in a futures contract to sell the stock after the ex-dividend date – and successfully generate arbitrage profits? We find that this dividend-capturing arbitrage strategy has been able to consistently produce significant, abnormal returns over our 19 year sample period. We find that even after incorporating explicit transaction costs and collateral requirements, a small domestic investor is able to generate between 0.86% and 2.83% monthly abnormal returns with the top 10 percent of profitable observations in financial year 2014.