Security Futures Tied to Dividend Whipping Post

Let's take General Motors(GM Quote) and its 5.11% yield. On Jan. 10, the stock settled at $39.11, and a June 2003 future settled at $38.31, virtually at its fair value given a 1.25% interest rate.

If GM doesn't move between now and June 20, the seller of the future will lose 80 cents. The holder of the stock should receive two 50-cent quarterly dividend payments. The remaining 20 cents is the interest rate differential paid by the GM holder. We should expect a drop of $1.00 in GM's price to reflect the dividend payouts; this will benefit the short future and hurt the long stock. Prior to tax treatment, everyone is equal.

But after taxes, you win. The $1.00 in dividends is yours tax free, and you deliver the GM stock against the short June 2003 future at $38.31 for an 80-cent short-term capital loss. Your risk in the trade is that GM will slash its dividend by more than 10 cents per quarter.

So long as the June 2003 future can be sold for any amount over $38.11, the tax arbitrage remains open. If traders start piling onto the long stock/short single-stock future trade, we could see the forward curve for single-stock futures invert, with June trading below $38.11.

How low could it go? The marginal buyer with a 38.6% short-term capital gains rate would need to pay ($38.31 - ((1-0.386) * 0.80)), or $37.82, to achieve complete parity with the long stock owner.

I haven't examined all of the other implications of the Bush tax proposal yet, but I'm pretty sure they're as equally straightforward.