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1 SCHOOL OF FINANCE AND ECONOMICS UTS:BUSINESS WORKING PAPER NO. 92 OCTOBER, 1999 Do Ex-Dividend Drop-Offs Differ Across Markets? Evidence from Internationally Traded (ADR) Stocks V.T. Alaganar Graham Partington Max Stevenson ISSN:

2 Do Ex-dividend Drop-offs Differ Across Markets? Evidence From Internationally Traded (ADR) Stocks V.T. Alaganar, G. H. Partington and M. Stevenson The authors are from the School of Finance and Economics University of Technology-Sydney, Australia Abstract This paper investigates whether the ex-dividend drop-offs for ADRs differ from the ex-dividend drop-offs of their underlying Australian stocks. An expected source of difference in the valuation of dividends, and hence in the drop-offs, is the availability of imputation tax credits to Australian resident investors. Valuation differences across markets present an arbitrage opportunity, but we hypothesize that transaction costs and risk will inhibit arbitrage and that the valuation difference will persist. Our results are consistent with this hypothesis. The ADRs have lower drop-offs and behave more like stocks taxed under a classical system than the underlying Australian stocks. JEL Classification Codes: G12, G15, G35 Keywords: Ex-dividend, ADR, Drop-off ratio, imputation tax, arbitrage Address for correspondence: Dr. V.T. Alaganar School of Finance and Economics, University of Technology Sydney, P.O. Box 123 Broadway, NSW 2007, Australia Vt.Alaganar@uts.edu.au Fax: Phone: Do Ex-dividend Drop-offs Differ Across Markets? 2

3 Evidence From Internationally Traded (ADR) Stocks 1. Introduction The purpose of this paper is to determine whether, for internationally traded stocks, the exdividend price drop differs between the domestic market 1 and the overseas market. This investigation has relevance for several research questions. For example, do domestic tax arrangements affect the prices of internationally traded stocks, or are international capital markets so well integrated that arbitrage trades equalize the drop-off ratios? Our analysis involves Australian stocks traded domestically and traded in the United States as American Depositary 2 Receipts (ADRs). An interesting feature of this analysis is that Australian stocks are taxed under a full imputation system. Under this system, resident Australian investors (domestic investors) are able to recover all the corporate tax paid on dividends via a system of tax credits. These credits are known as imputation tax credits, or franking credits. We examine whether imputation tax credits make Australian dividends more valuable to domestic shareholders, than to international shareholders holding ADRs. This is accomplished by comparing ex-dividend day drop-off ratios 3 for the domestically traded stock and the ADR. We find these drop-off ratios differ. Our results suggest that the ex-day drop-off ratios for ADRs 1 The term domestic market refers to the country of the home exchange for the underlying stock. In this case, the Australian market. 2 Two spellings are possible for depositary. The alternative is depository, but depositary is favored by the depositary banks. 3 The drop-off ratio is a standard statistic used to compare drop-offs across companies. It is defined as the ex-dividend price drop divided by the dividend. 3

4 behave more like stocks taxed under a classical tax system, than the underlying Australian stocks. 4 The Australian stocks have a higher drop-off ratio than the ADRs. There are three implications that arise from this result. First, that imputation credits have value to Australian investors, but little or no value to overseas ADR investors. Second, that there are barriers (transactions cost and risks) to international dividend stripping which, for example, prevent arbitrageurs buying dividends in the ADR market in which the dividends have a lower price. Third, legal restrictions on trading imputation credits, and the cost of circumventing those restrictions, have an effect on the value of dividends. If imputation credits could be freely traded their value should be fully reflected in the ADR drop-off. Our results suggest that domestic tax arrangements do affect the pricing of internationally traded stocks on the ex-dividend date and, in this respect, international capital markets are not fully integrated. This paper is organized as follows. A description of the ADR market is presented in the next section (Section 1). Differences between the Australian and U.S. equity markets, which are important for this study, are also included in Section 1. In Section 2 we develop our hypothesis, which arises from a discussion of research related to ADRs and to Australian and U.S. exdividend price behavior. Data and data sources are discussed in Section 3. Results are presented in Section 4, while Section 5 contains concluding remarks. 4 This behavior is similar to the behavior of Australian stocks that pay dividends without any imputation tax credits. 4

5 1.1. ADRs and the Differences between Markets A depositary receipt is a negotiable receipt representing equity in a non-u.s. company. A depositary bank in the U.S. issues ADRs, and each ADR is backed by a fixed number of underlying shares in the custody of a bank (called the custodian bank) in the domestic market. The depositary bank carries out the responsibilities with respect to the payment of dividends and shareholder voting as stated in the ADR agreement. The objective in creating the ADR is to reproduce the same rights and benefits for the ADR holders as they would obtain by holding the underlying stock. The sponsored ADRs that we study are treated in the same manner as other U.S. securities for legal and administrative purposes. They can be listed on any of the U.S. exchanges, and they must meet US disclosure requirements. Attributes of ADRs relevant to this study are (a) lower transaction costs and execution risks compared to direct purchase in the overseas market and (b) pricing is in US dollars and dividend payments are made in US dollars. Trading of ADRs is simplified by the ability to transfer ownership in the books of the depositary bank. The supply of an ADR is not fixed, and can be changed by the actions of investors. For example, an investor can either purchase existing ADRs in the U.S., or purchase underlying shares in the domestic market and have new ADRs issued by the depositary bank in exchange for depositing the shares. The reverse trade called 'flowback' occurs when ADRs are cancelled in the U.S. and the underlying shares are released in the domestic market. Trading within the U.S. market accounts for the bulk of ADR trading volume but there is a small quantity of inter-market trades. 5 These inter-market trades result in the number of available ADRs changing as investors attempt to exploit arbitrage opportunities between the markets. One important distinction between the underlying stock and the ADR is that one ADR is not necessarily equal to one underlying share. The custodial bank will bundle the underlying shares into a package that will trade in a price range broadly comparable with shares traded in the U.S. market. The ADR can therefore represent more or less than one share of the underlying stock. The number of shares of stock represented by the ADR is known as the conversion ratio. In the case of Australian stocks, the conversion ratio is generally greater than one Difference in Taxes between Markets A major difference between the Australian and U.S. equity markets is in the tax regimes that they operate under. The U.S. operates a classical tax system in which taxes are levied on corporate profits and shareholders also pay taxes on dividends distributed from those profits. In contrast, Australia operates a full imputation system. From the point of view of an Australian resident, only personal tax is paid on corporate income distributed as dividends. The system works as follows. Suppose an investor with a tax rate, t d, receives a dividend, D, distributed from profits fully taxed at the corporate tax rate, t c. The investor s income tax liability is calculated by grossing up the dividend to the equivalent share of pre-tax corporate income, and tax is assessed on that amount. Thus the investor s tax liability is given by (D/1-t c )t d. However, the investor also receives an imputation tax credit known as a franking credit. The franking credit is the full amount of corporate tax paid on the dividend received, which is given by (D/1-t c )t c. Thus the tax the investor actually pays is given by (D/1-t c )(t d - t c ). Investors with a personal tax rate above the corporate rate will, therefore, have some extra tax to pay, while investors with a personal tax rate 5 According to the Bank of New York ( about 95 % of the ADR trading is within the US market and about five percent is intermarket trading. 5

6 less than the corporate rate will have a surplus credit. The surplus credit can be used to offset tax on other income. It is not legal to buy and sell imputation credits. Not all of a company s income may have been subject to Australian corporate tax, in which case a tax credit is only available to the extent of company tax paid. Under these circumstances, dividends are labeled partially franked. This distinguishes them from fully franked dividends where company profits have been fully taxed. With one exception non-resident investors do not benefit from the franking credit. The exception is in regard to withholding tax. Dividends paid to investors outside Australia are subject to a withholding tax. This tax is 15 % in the case of U.S. investors 6. However, franking credits can be used to offset withholding tax, so the overseas recipients of fully franked dividends pay no withholding tax. The only benefit of avoiding the witholding tax is a limited timing benefit to U.S. investors, who would if they paid the tax be able to claim that withholding tax as an offset to their U.S. tax liability. The timing benefit is in the avoidance of the immediate cash outflow, which the deduction of Australian withholding tax would otherwise entail. The U.S. holder of an ADR on a stock paying franked dividends will receive the full value of the dividend. No withholding tax will have been levied and the franking credit will expire unused.. From the tax perspective of a U.S. investor, the ADR dividend will look much like a dividend received from a U.S. company. If, however, Australian residents held ADRs, then they could claim the franking credit. 7 From their tax perspective, the dividends from ADRs would look much like the dividends from the underlying stocks, but the dividends would be in U.S. dollars. Attempts to restrict dividend stripping are present in both the U.S. and Australian equity markets, but are more developed in the U.S. market. In the U.S. market the tax concession on intercorporate dividends is not allowed if the stock is held for less than 45 days. A similar rule restricting access to franking credits was announced for the Australian market in the 1997 budget, but, by the start of 1999, the proposed 45-day rule had still not become law Timing Differences There are some timing effects across the U.S. and Australian equity markets that are relevant to this study. First, major equity markets in the two countries are never open simultaneously. Consequently, a riskless arbitrage requires taking a derivative position to hedge price risk in the period between one market closing and the other opening. Second, the ex-dividend date usually differs between the two markets. The setting of the dividend record date for the ADRs is usually a matter of agreement between the company issuing the underlying shares and the depositary bank. In our data the underlying 6 The withholding tax rate is 30 %, but this is reduced to 15 % under the US-Australia double taxation treaty. 7 Both the depositary banks and the Australian Tax Office have confirmed that the franking credit is available to Australian residents holding ADRs. 8 The Australian rule was to be backdated to the date of the budget announcement, but the proposal has been subject to substantial revision. Partington and Walker (1999) show that this change did not affect the pricing of dividends. 6

7 stock and the ADR often have the same record date. However, this does not necessarily mean that they will have the same ex-dividend date. During the 1990s the Australian market set the exdividend day seven business days before the record date, while the ex-dividend date in the U.S. market has been set as five business days before the record date. Thus, where the record date is the same, we expect the Australian ex-date to lead the U.S. ex-date and this is predominantly the case. However, the record date is not the same in all cases, as a result the ADR ex-date can lag or lead the ex-date in Australia. The difference between the two ex-dates is only a few days, and in our data it never exceeded five business days. A final timing difference between the two markets is the frequency of dividend payments. In the U.S. companies generally pay quarterly dividends, while in Australia dividends are paid every six months. Since the ADRs mimic the underlying Australian stock they too pay half-yearly dividends. This makes the dividend yield, measured as each payment (not annualized) divided by the share price appear higher for Australian stocks and ADRs compared to U.S. stocks. 2. Development of Hypothesis The ex-dividend price drop-off has been the subject of many studies. Beginning with Elton and Gruber (1970) and Kalay (1982), there has been a continuing debate about whether long term investors (tax clienteles) or short-term investors (arbitrageurs) determine prices about the exdividend date. Elton and Gruber argue that for long term investors, under a classical tax system with a tax advantage to capital gains, the equilibrium drop-off ratio is less than one. This, however, presents an arbitrage opportunity for short-term traders. Kalay argued that the equilibrium drop-off ratio had to be one to prevent arbitrage by tax-neutral investors. 9 Such trading might, of course, be inhibited by transactions costs. For example, Koski (1996) points out that the bid-ask spread is an important component of transactions costs, and observes, Shortterm traders can eliminate abnormal ex-dividend returns caused by tax clientele trading only up to the bounds imposed by transactions costs, Koski (1996, p.318). The implication is that both long term and short-term traders can be active in the market about the ex-dividend date. In our study we consider the possibility that four classes of traders could be active in the market about the ex-dividend date. Both the long-term and short-term traders can be sub-divided into American and Australian investors. The latter are tax advantaged by the imputation tax credit. Koski s (1996) statement above still holds, but in addition, the Australian investors can exploit their tax advantage only up to the bounds imposed by transactions costs. Thus we would expect equilibrium in each market to be determined by the balance between long-term and short-term investors and the costs of trading between the markets. There is a substantial body of evidence that, in the U.S., prices decline on the ex-dividend date by less than the dividend. In much of this work researchers examine rates of return about the exdividend date instead of calculating drop-off ratios. Eades, Hess and Kim (1984), Lakonishok 9 Tax neutral investors face equal taxes on dividends and capital gains. 7

8 and Vermaelen (1986) Karpoff and Walkling (1988), and Grammatikos (1989) all found positive abnormal returns on ex-dividend days (price drops less than the dividend). Since abnormal returns were not eliminated, the implication is that arbitrage was inhibited by transactions costs. The papers cited above also provide evidence of short-term traders engaged in dividend stripping, particularly for high yielding shares. A concentration of dividend stripping in the higher yielding stocks is to be expected, because transaction costs are a smaller proportion of the dividend. With regard to ADRs and the Australian stocks, if short-term traders are active, the implication is that higher drop-offs should be associated with the higher yielding stocks and their ADRs. A drop-off ratio less than one has traditionally been explained in terms of a tax disadvantage, under a classical tax system, for dividends relative to capital gains. However, Frank and Jagannathan (1998) argue that, even in the absence of tax effects, the equilibrium drop-off can be less than one because of a market s microstructure. Indeed, they argue that receipt of dividends can have a nuisance cost to some investors. It is noteworthy in this context, that in our discussions with representatives of the depositary banks, we were told that ADR investors were not particularly interested in the dividends, but were more interested in capital gains and the diversification benefits of ADRs. The importance of diversification benefits to ADR investors is supported by survey results referenced in Malnak and Sedlisky (1994, p.205). In Australia, the drop-off ratio has increased post imputation, although Brown and Clarke s (1993) results suggest that there was a lagged response to the tax change. Bellamy (1994) shows that stocks paying franked dividends have a significantly higher drop-off than stocks paying unfranked dividends, averaging 0.89 and 0.66 respectively. The question is whether a similar relationship will exist between the Australian stocks and their ADRs. For stocks paying fully franked dividends, a much higher drop-off ratio of 1.23 was reported by Walker and Partington (1999). They were able to use data on cum-dividend trading in the ex-dividend period that provided a very clean measure of the value of dividends net of transactions costs. The drop-off ratio so derived was higher than Bellamy s for two reasons. First, Walker and Partington s sample was primarily of higher dividend yield stocks where the transaction cost effects are 8

9 proportionately less. Second, Walker and Partington show that the traditional ex-dividend study based on close to close prices gave a lower drop-off ratio, which they suggest is downward biased. The area of ADR research relevant to this study is concerned with efficiency of pricing, particularly the absence of arbitrage opportunities between the markets. Within the ADR market Rosenthal (1983) concludes that prices are reasonably consistent with weak form efficiency. The evidence on the efficiency of pricing between markets generally finds against the existence of arbitrage opportunities between ADRs and their underlying stocks [see Officer and Hoffmeister (1987), Kato, Linn and Schallheim (1991) and Wahab and Khandwala (1993)]. An exception is Wahab, Lashgari and Cohn (1992) who find potential for arbitrage, provided the investor can construct ex-ante portfolios that are ex-post mean-variance efficient. In analyzing the relation between drop-off ratios in the two markets, the literature discussed above can be reduced to two competing arguments. The first emphasizes the differing tax clienteles and the second focuses on market efficiency, with arbitrage eliminating any differences in dividend valuation. 2.1 Tax Advantage Argument Dividends are tax advantaged from the point of view of an Australian investor relative to a U.S. investor. 10 If the two markets were completely segregated the tax advantage in the Australian market should lead to a higher value for dividends and, therefore, to a higher ex-dividend dropoff ratio in that market. The drop-off will be higher for Australian short-term traders relative to U.S. short-term traders, and for Australian long-term traders relative to the U.S. long-term traders. This can be seen as follows. Consider a short-term trader in the U.S. buying the ADR on the last cum-dividend day at a price P cum and selling the ADR on the ex-dividend day at a price P ex. The investor gets the dividend on which tax is payable at the rate t d, but there is also a potential gains tax benefit on the ex- 10 This statement assumes the absence of mechanisms to circumvent legal restrictions on the trading of imputation credits, or that the creation of such mechanisms has a significant cost. 9

10 dividend price drop at the rate t g. Ignoring transaction costs and timing effects on cash flows, and assuming the availability of the gains tax benefit, the no arbitrage condition is: P ex + D(1- t d ) + t g (P cum P ex ) - P cum = 0 (1) Rearranging Eq. (1), the drop off ratio is given by: P cum P D ex 1 t = 1 t d g (2) This is the same equation which Elton and Gruber (1970) derive as the equilibrium for long term traders in the U.S. For tax-neutral short term traders, however, t d and t g are equal, and from Eq.(2) we observe their equilibrium drop off ratio to be one. For an Australian short-term trader buying the share, the cash flows are the same as for the U.S. short-term trader holding the ADR, except that the Australian investor is taxed on the grossed up value of the dividend, (D/1-t c )t d, and also gets the imputation tax credit, which we earlier showed was (D/1-t c )t c. So the no arbitrage condition becomes: P ex + D + (D/1-t c )t c - (D/1-t c )t d + t g (P cum P ex ) - P cum = 0 (3) Rearranging Eq. (3), the drop-off ratio can be expressed as follows. P cum P D ex = 1 td (1 t )(1 t ) g c (4) Clearly, as long as t c is positive, Eq. (4) gives a higher drop-off ratio than that from Eq. (2) for the U.S. case. For the Australian tax-neutral short-term trader the equilibrium drop-off becomes 1/(1-t c ). This is equivalent to valuing the dividend at its face value plus the face value of the franking credit. The analysis above has been simplified by ignoring the effect of time lags in relation to both the receipt of dividends and the cash flows associated with taxes. Transaction costs and uncertainty about the ex-dividend price have been ignored. Equality of income and gains tax rates between 10

11 the two markets has also been assumed. These assumptions could be relaxed and additional variables could be incorporated into the models. This would add complexity to the models, but would not change our basic point. Given segregation of the markets, and tax rates that are not too dissimilar between the markets, the drop-off ratio in Australia should be higher. This is because of the additional value arising from the imputation tax credit. However, it is important to note that because of transactions costs we would expect actual drop-off ratios to be considerably less than the values implied by the theoretical models above. 2.2 Integrated Global Market Argument In an efficient international capital market, and in the absence of transactions costs, foreign exchange risk, execution risk and price risk, differences in ex-dividend drop-offs should be eliminated through arbitrage. However, the very existence of ADRs is prima facie evidence that the costs and risks of international equity trading are not trivial. These costs include not only the transaction costs of executing trades internationally, but also the costs of managing any resulting foreign exchange exposure. As discussed above, the literature suggests that ADR pricing is such as to preclude profitable arbitrage between the ADR and the domestic markets. Thus, it appears that the transactions costs and associated risks are not a major source of disequilibrium in these studies. However, in ex-dividend arbitrage by short-term traders, for example dividend strips, there are some additional sources of cost and risk that are not accounted for in the existing ADR literature. For example, the time lag between the ex-date prices in the two markets creates a significant price risk. As Michaely and Vila (1996) observe, the ex-date price risk is non-trivial, even where we are only considering the overnight price gap for U.S. stocks. How much greater then will be the risk where the short-term trader not only faces price uncertainty, but also faces a foreign 11

12 exchange exposure. Furthermore, even for purely domestic U.S. stocks, transactions costs are sufficient to limit ex-date arbitrage. For example, Koski (1996) shows that at observed prices, tax-neutral short-term traders could not profit after transactions costs, and opportunities for dividend capture by tax advantaged corporations were also limited. We expect the transactions cost limits on international arbitrage to be even greater. On balance, we think the tax advantage argument has more weight than the arbitrage argument. We, therefore, hypothesize that the drop-off in the Australian market will be higher than in the U.S. market. Reversing this hypothesis gives us the formal statement of the null: H 0 : Drop-off in Australia =< Drop-off in U.S. Market microstructure effects can affect drop-off ratios, Bali and Hite (1998) and Koski (1996). Therefore, microstructure differences between markets, particularly in transactions costs and spreads, could lead to a difference in drop-off ratios. To control for these effects requires access to market microstructure data that we could not obtain. However, the evidence of Gorman (1998) suggests that total transaction costs and spreads are higher in Australia than in the USA. 11 This would bias the ADR drop-off ratios upwards relative to the Australian stocks, which is the opposite of what we hypothesize. Thus our testing of the null can be viewed as conservative. A secondary hypothesis arises from transaction cost effects. As discussed earlier, higher dropoffs are associated with higher dividend yields, and this appears to be a consequence of the activities of short- term traders inhibited by transactions costs. Assuming the presence of such traders in the markets for the Australian stocks and their ADRs then the price drop-off in both markets should increase with the dividend yield. 3. Data 11 Gorman reports total roundtrip transaction costs of 119 basis point for the Australian market including a spread of 62 basis points, while for the USA he reports total transaction costs of 51 basis points including a spread of 43 basis points. 12

13 Our sample consists of Australian stocks paying fully franked dividends, which have their ADRs traded in the U.S. We identify 23 Australian stocks meeting these criteria. We restrict our sample to fully franked dividends in order to reduce heterogeneity in dividend valuations. In any event, only a minority of stocks pays partially franked dividends and these dividends are generally small. This data covers the period We select this period because the imputation system was introduced to Australia during With the exception of information on the level of franking, all data is obtained from Datastream International. Information on the level of franking comes from the Beacon on-line data service. For the Australian stocks that pay fully franked dividends, we extract closing prices for both the ex-dividend day and the last cum-dividend day, and the face value of dividends. All these measurements are in Australian dollars. For each Australian stock s ex-date event there is a corresponding ADR ex-date event, although these events may be on different calendar dates. For the ADRs we collect the closing price on the last cum-dividend day, the closing price on the ex-dividend day and the magnitude of the dividend. All these measurements are in U.S. dollars. We exclude from the sample observations where measurement of the ex-dividend drop-off spanned public holidays in either country. 12 We also obtain the exchange rate between the Australian dollar and the U.S. dollar and the conversion ratio for the ADR. 12 We drop these observations for two reasons. First, Datastream pads holiday records with the last price, which is inappropriate to our study. Second, deletion of holidays helps reduce noise when the exdividend drop-off is used as a measure of the value of dividends. The greater the time separation between the observation of cum-dividend and ex-dividend prices the greater the chance that other variables will confound this price difference. 13

14 Some stocks have observations spanning the full period, 1988 to 1998, while in other cases it was only possible to match for a subset of years. About 70 percent of the observations occur from when more ADR programs were being created. 4. Results Summary statistics for both the underlying stocks and the ADRs are contained in Table 1. Panel A provides a comparison between the ADRs and the underlying Australian stocks for the full sample of 199 matched pairs of drop-offs. The price, P cum, and dividend, D, are stated in Australian dollars for the Australian stocks and in U.S. dollars for the ADRs. They therefore reflect the raw data that traders observe in each market. It is noticeable that the magnitudes of these variables are greater for the ADRs. This is due to the bundling of the underlying shares in creating the ADR, where the conversion ratio is generally greater than one. Notice however, that once the price drop-off and dividend yield ratios are formed, the scaling and currency effects cancel in the numerator and denominator of the ratios. This can be most clearly seen in the dividend yield, where the summary statistics are almost identical, as they should be if the ADRs truly reproduce the underlying stock. Extreme observations in drop-off ratios can be driven by small dividends. Therefore, in ex-dividend research it is common practice to present results both with and without the small dividend cases. In Panel B (Table 1) we present the results after excluding the cases in which the ADRs paid a dividend of U.S.$0.05 or less. This only eliminates six matched pairs and the summary statistics showed relatively little change. TABLE 1 ABOUT HERE The most interesting result is the comparison between the drop-off ratios for the two markets. The mean drop-off-ratio for the Australian traded stocks, excluding small dividend cases is 0.86 which is comparable to Bellamy s (1994) value of 0.89 for a broader sample of Australian stocks 14

15 with franked dividends. This drop off for the Australian stocks is noticeably higher than the corresponding ADR ratio at A similar pattern is apparent in the medians, which are 1.00 and 0.40 respectively. Similar results obtain for the full sample, although both the Australian and US drop-off ratios are slightly lower in this case. For the full sample, using a matched pairs t-test we are unable to reject the null hypothesis, that the drop-off in Australia is less than or equal to that in the U.S. However, this test is not well specified as the distributions of the drop off ratios strongly violate normality, and the power of the test is low. A more appropriate test in this case is the Wilcoxon matched pairs signed rank test. The results of this test strongly indicate that the null should be rejected. When small dividend cases are excluded, both the matched pairs t-test and the Wilcoxon matched pairs test support the rejection of the null hypothesis. In subsequent analysis we use the full sample of observations including the small dividend cases. In these analyses we utilize the Wilcoxon matched pairs signed rank test for paired comparisons, and the Wilcoxon rank sum test for non-matched comparisons. 13 We do this to overcome the problem of mis-specification in both the paired t-test and the t-test. Researchers such as Boyd and Jagannathan (1994) and Frank and Jagannathan (1998) have approached the estimation of drop-off ratios using a regression model. They regress the price drop-off divided by the cum-dividend price against the dividend yield. The slope coefficient from the resulting regression is an estimate of the drop-off ratio. The specification for the regression is given by equation (5): (P cum -P ex )/P cum = α + β D/ P cum + ε. (5) 13 Replicating these analyses, and the regression analysis, with the small dividend cases deleted gave essentially the same results. 15

16 To this regression, we add a constant dummy and a slope dummy for the ADRs. The resulting regression is given by equation (6). (P cum -P ex )/P cum = α + β 1 A + β 2 (D/P cum )+ β 3 A(D/P cum ) + ε (6) Where: A = 1 if the security is an ADR and zero if it is an Australian stock. This regression provides an alternative test for the significance of the difference in drop-off ratios between the markets, and provides alternative estimates of the drop-off ratios. Since the regression pools both the Australian and U.S. data, we ensure dimensional consistency by converting the observations to a common measurement base. Two adjustments are required; one is to convert to a common currency, while the second is to adjust for differences in scale caused by the ADR conversion ratio. We therefore convert the Australian prices and dividends to U.S. dollars, and then scale them up by multiplying by the ADR conversion ratio. In estimating the regression we correct the standard errors for heteroscadesticty by using White s heteroscadesticty consistent covariance estimator. TABLE 2 ABOUT HERE The regression given in Eq. (6) is expected to produce a positive and significant slope coefficient on the dividend yield, and a negative and significant coefficient on the slope dummy, reflecting a lower drop-off ratio for the ADR s. The intercept is expected to be small negative and significant being a function of transactions costs. 14 The results of the regression are shown in Table 2. These results are consistent with our expectations. The estimated drop-off ratio for the Australian stocks is 1.33, adjusting for the ADR slope dummy gives a drop-off ratio of 0.52 for the ADRs. In the case of the Australian estimate, the drop-off ratio is considerably higher than the average value reported in Table 1. The estimate here is much closer to that reported by Walker 14 This can be seen by taking equation (8) developed later in the paper and transforming it to the form of equation (5) 16

17 and Partington (1999). If there are effects arising from transaction cost differences within each market, they do not show up in the intercept dummy, which is small and not significant. We next consider whether the drop-off ratios for the stocks and their ADRs have changed over time, and whether the differences between the two markets are persistent. We do this for two reasons. First, the results of Eades, Hess, and Kim (1994) show that there can be substantial time series variation in abnormal returns and hence in dividend valuation. Second and more importantly, there are some influences that might have reduced the difference in drop-offs between the two markets over time. Both the number of ADR programs and the volume of trading have grown strongly in recent years. With increasing liquidity, potential arbitrage opportunities are more likely to be eliminated. To examine this issue, we split the sample of 199 observations into two. We make the split at the beginning of We chose this timing because it provides an approximately equal number of observations before and after the split, and also because the growth in trading volume was strongest from 1995 onwards 15. TABLE 3 ABOUT HERE Summary statistics for drop-off ratios for Australian stocks and their ADRs for pre-1995 and post periods are presented in Table 3. These results show very little change between the two periods. The changes observed, through time within each market, are not statistically significant according to the Wilcoxon rank sum test. The lack of change within markets is consistent with a persistent difference between the two markets both pre- and post The significance of these differences is confirmed by the Wilcoxon matched pairs signed rank test. 15 This can be seen by examining the statistics on trading volume at the Bank of New York web site ( From 1995 through 1999 the trading volume was nearly double the volume from the start of the decade to the end of

18 Following Elton and Gruber (1970) it has been well documented that drop-off ratios tend to be higher for higher dividend yield cases. We investigate whether the drop-offs in our study vary with the dividend yield. We rank each drop-off ratio by the magnitude of D/P cum. We then form six dividend yield classes as given in Table 4. We also present in Fig. 1 (Australian stocks) and Fig. 2 (ADRs), box plots of the drop-off ratio for the six dividend yield classes. An interesting feature of the box plots for the Australian stocks is the monotonic reduction in variability of the drop-off ratio as the yield increases. 16 This is consistent with convergence of the drop-off ratios at higher yields towards the limiting value that would exist in the absence of transactions costs. At these higher yields the transactions costs become relatively less important as a fraction of the dividend. FIGURES 1 AND 2 ABOUT HERE The box plots suggest that the variance of the drop-off ratio differs across the dividend yield classes. This is confirmed in formal testing by the Modified-Levene equal variance test, which strongly rejects the hypothesis of equality of variance across the dividend yield classes. The Modified-Levene test statistic for Australian stocks is F = (p = 0.00) and the statistic for the ADRs is F = (p = 0.00). The data also fails the D Agostino Omnibus test for normality. The test statistic, K 2, approximates a Chi-square distribution where, for this case K 2 = (p= 0.00). Therefore, the standard analysis of variance technique is not well specified for this data. We therefore use the non-parametric Kruskal-Wallis analysis of variance. 17 This 16 The box plots are drawn to the same scale, and have been scaled to include the outliers. This scaling makes differences in the median values, and the declining variance, less obvious than if the plot had been presented on a larger scale with the outliers truncated. 17 The Kruskal-Wallis test also requires equality of variances, but is less sensitive to outliers than the 18

19 allows us to test for differences in drop-off ratios across dividend yield classes within each market, but not to jointly test for differences between markets. TABLE 4 ABOUT HERE Table 4 shows that for the Australian stocks, with one exception, the magnitude of the drop-off ratio increases monotonically with the dividend yield, and the two highest yield classes have mean drop-off ratios exceeding one. The Kruskal-Wallis test shows that the differences in dropoff ratios across the Australian yield classifications are statistically significant. The ADRs also show a monotonic increase in drop-off ratios for dividend yield classes above 1.5 percent, but in contrast to the Australian data, the difference in ADRs is not significant. 4.1 Limits to Arbitrage The evidence clearly suggests that the drop-off ratios differ between the two markets. The question is why this potential arbitrage opportunity persists. In Section 2 we hypothesize that transactions costs and risks would drive such a result. Here we examine the magnitude of the implied transaction costs that would sustain the difference in drop-off ratios. We expand the model developed from the no-arbitrage condition for dividend strips by Australian investors as given by Eq. (3). We add a transactions cost variable, a, which is the transaction costs as a percent of the price at which a transaction occurs. The resulting no arbitrage equation is: P ex (1- a) + D + (D/1-t c )t c - (D/1-t c )t d + t g (P cum (1 + a) P ex (1- a)) - P cum (1 + a) = 0 (7) Rearranging to get the drop-off ratio on the left-hand side gives: P cum P D ex 1 td 2a P = tg tc a (1 )(1 )(1 ) 1 a D cum (8) parametric analysis of variance. 19

20 We derive the value of a by solving Eq. (8) as follows. The mean value of the drop-off from Table 1 is substituted into the left-hand side of Eq. (8), while the mean value for the dividend yield is substituted into the right-hand side. We substitute the Australian corporate tax rate of 0.36 for t c. For the taxes on dividends and capital gains (that is t d and t g respectively) we substitute the top personal income tax rate The results are not sensitive to the choice of this rate as long as t d and t g are equal. We assume equality of tax rates for income and capital gains, because in Australia share traders are taxed on capital gains as income and other investors pay gains taxes at their marginal income tax rate. 18 Using the data from Table 1, Panel B for Australian stocks, the implied value of a is 0.78 %, or 1.56 % for a round trip trade. 19 This level of transaction costs represents the upper limit on average transaction costs. Beyond this level an Australian investor could not profit from a dividend strip in the domestic market, given the average drop-off ratio and the average dividend yield. Although we call variable a transaction costs, it also reflects a discount for risk associated with uncertainty over the ex-dividend price, and a discount for the lag in dividend and tax cash flows. Using the data from Table 1, Panel B for ADRs, the implied value of a is 1.13 %, or 2.26 % for a round trip trade. This level of transaction costs represents the upper limit on average transaction costs for ADRs. Beyond this level an Australian investor could not profit from a dividend strip in the ADR market, given the average ADR drop-off ratio and the average ADR dividend yield. The difference on the implied round trip transaction costs in the two markets is 0.70 %. In other words, if transacting in the ADR market is 0.70 % more expensive for the Australian investor, 18 This creates a problem for backing out the investor s marginal tax rate from equation (8). As long as gains tax and dividend tax rates are equal the ratio of these rates is one and equation (8) will give the same drop-off ratio for any marginal tax rate. 19 In Australia, it is estimated that institutional investors faced commissions plus taxes ranging from 90 basis points to 160 basis points per round trip, while the range for private investors was 130 to 260 basis points, Walker and Partington (1999). 20

21 then there is no arbitrage profit to be made from exploiting the average difference in drop-off ratios. For a profitable arbitrage, the 0.70 % has to cover the additional costs of trading internationally including the costs of three sets of currency conversion, in buying and selling the ADRs and converting the dividend, plus the cost of hedging the foreign exchange risks. This does not seem to leave much margin, if any, for profit. 5. Conclusion Comparison of the drop-off ratios shows that the drop-off ratio for Australian stocks is significantly greater than for the ADRs. Our results suggest that there has been no significant change in this relationship over the period studied. Furthermore, the Australian stocks show a statistically significant pattern of increasing magnitude and decreasing variance for the drop-off ratios as dividend yield increases. In contrast, there is no statistically significant evidence that the ADR drop-off ratios increase with dividend yield. The patterns observed are consistent with the ADRs being substantially held by U.S. investors who are long-term traders. If short-term traders were driving the ADR ex-dividend market, then the drop-off ratio should rise significantly with the dividend yield class. While the mean ADR drop-off ratios do tend to rise with the dividend yield, the increase is not statistically significant. ADRs might be less attractive to short term traders due to difficulties in establishing derivative positions to hedge share price risk. 20 Also, the US corporations traditionally engaged in dividend capture would not be expected to obtain the same tax advantages in the ADR market. The drop-off ratios for the Australian stocks appear to impound the extra value provided by the franking credit. The pattern in the drop-off ratios is consistent with the Australian stocks being 20 The evidence of Grammatikos (1989) suggests that short term traders are more likely to be active in stocks in which short term traders can use derivatives to hedge their price risk. 21

22 held by a mixture of long-term and short-term traders. The dominance of short-term traders in higher dividend yield classes would tend to both tighten the boundaries of the drop-off ratio and drive the value above one. This is exactly what we observe. The evidence from prior studies within one market, is that short-term trading such as dividend strips are constrained by transactions cost. Our evidence is that the same conclusion applies to international markets. As a result, ex-dividend pricing does differ where different markets have different tax regimes. It appears that arbitrage trades do not equalize the price drop-offs because of the transaction costs and risks that such trades would incur. 22

23 References: Bali, R. and Hite, G., Ex Dividend Day Stock Price Behavior: Discreteness Or Tax- Induced Clienteles?, Journal of Financial Economics, Bellamy, D. E., Evidence of Imputation Clienteles in the Australian Equity Market, Asia Pacific Journal of Management 11, Boyd, J. and Jagannathan, R., Ex-Dividend Price Behavior of Common Stocks, The Review of Financial Studies 7, Brown, P. and Clarke, A., The Ex-Dividend Day Behavior of Australian Share Prices Before and After Dividend Imputation, Australian Journal of Management, 18, Eades, K., Hess, P., and Kim, E.H., On Interpreting Security Returns During the Ex- Dividend Period, Journal of Financial Economics 13, Eades, K., Hess, P. and Kim, E.H., Time-Series Variation in Dividend Pricing, Journal of Finance 49, Elton, E. and Gruber, M. J., Marginal Stockholder Tax Rates and the Clientele Effect, Review of Economics and Statistics 52, Frank, M. and Jagannathan, R., Why do Stock Prices Drop by Less than the Value of the Dividend? Evidence from a Country Without Taxes, Journal of Financial Economics 47, Gorman, S.A., 1998, The International Equity Commitment, Institute of Chartered Financial Analysts. Grammatikos, T., Dividend Stripping, Risk Exposure, and the Effect of the 1984 Tax Reform Act on the Ex-Dividend Behavior, Journal of Business 62, Kalay, A., The Ex-Dividend Day Behavior of Stock Prices: A Re-Examination of the Clientele Effect, Journal of Finance 37, Karpoff, J., and Walkling, R., Short-Term Trading Around Ex-Dividend Days: Additional Evidence, Journal of Financial Economics 21, Kato, K., Linn, S. and Schallheim, J., Are There Arbitrage Opportunities in the Market for American Depository Receipts? Journal of International Financial Markets, Institutions & Money 1, Koski, J. L., A Microstructure Analysis of Ex-dividend behavior Before and After the 1984 and 1986 Tax Reform Acts, Journal of Business 69, Lakonishok, J., and Vermaelen, T., Tax-Induced Trading Around Ex-Dividend Days, Journal of Financial Economics 16, Malnak, S. J. and Sedlisky, R., Foreign Stock Valuation: Separating Fact and Fiction, in Coyle, R. J. (Editor), The McGraw-Hill Handbook of American Depositary Receipts, (McGraw- Hill). Michaely, R. and Vila, J., Trading Volume with Private Valuation: Evidence from the Ex- Dividend Day, The Review of Financial Studies 9, Officer, D. and Hoffmeister, R., ADRs: A Substitute for the Real Thing? The Journal of Portfolio Management 13,

24 Partington, G. and Walker S., The 45-Day Rule: The Pricing of Dividends and the Crackdown on Trading in Imputation Credits, Accounting Association of Australia and New Zealand Conference, Cairns Rosenthal L., An Empirical Test of the Efficiency of the ADR Market, Journal of Banking and Finance 7, Wahab, M. and Khandwala, A., Why not Diversify Internationally with ADRs? The Journal of Portfolio Management 20, Wahab, M., Malek, L. and Cohn, R., Arbitrage Opportunities in the American Depository Receipts Market Revisited, Journal of International Financial Markets, Institutions and Money 2, Walker S. and Partington G., The Value of Dividends: Evidence from Cum-dividend Trading in the Ex-dividend Period, Accounting and Finance 39,

25 Table 1 Summary Statistics of Dividends and Ex-Day Variables of Australian Stocks and their ADRs: D = Dividends per share, P cum = Cum-price per share, P ex = Ex-price per share, (P cum P ex )/D = Drop-off ratio, D/ P cum = Semi-annual dividend yield Panel A - Matched Fully Franked Dividends (sample =199 ex-dates for each market) Variable Australian stocks (A$) ADRs (US$) Mean Median Minimum Maximum Std. Dev. Mean Median Minimum Maximum Std. Dev. D P cum (P cum P ex )/D D/P cum The distribution of the drop-off ratios fails the Shapiro-Wilks test for normality for both samples. (Australian stocks: W = 0.69, p = 0.00, ADRs: W = 0.56, p = 0.00). H 0 : Australian Drop-off Ratio =<ADR Drop-off Ratio. Paired t-test t= 1.34, (p = 0.09, one tailed); Wilcoxon matched pairs signed ranks test Z = 3.85 (p = 0.00, one tailed). Panel B - Matched Fully Franked Dividends with ADR dividend >US$0.05 (sample =193 ex-dates for each market) Variable Australian stocks (A$) ADRs (US$) Mean Median Minimum Maximum Std. Dev. Mean Median Minimum Maximum Std. Dev. D P cum (P cum P ex )/D D/P cum The distribution of the drop-off ratios fails the Shapiro-Wilks test for normality for both samples. (Australian stocks: W = 0.67, p = 0.00, ADRs: W = 0.83, p = 0.00). H 0 : Australian Drop-off Ratio =<ADR Drop-off Ratio. Paired t-test t = 2.15 (p = 0.02, one tailed); Wilcoxon matched pairs signed rank test Z = 4.25 (p = 0.00, one tailed). 25