Tax Clienteles, Arbitrage, and the Pricing of Total Return Equity Swaps

Abstract

The “swap” technology that originated with interest rates is rapidly being extended in many directions. One of the most interesting is toward “total return” swaps between equities and fixed income instruments. Chance and Rich have developed valuation formulas for equity swaps under standard assumptions, including the absence of taxes. But the U.S. tax code treats the two components of total equity return, dividends and capital gains, differently, while a swap payment is taxed at a single rate. As Laatsch shows in this article, the difference gives rise a kind of tax arbitrage, by which the relative attractiveness after taxes of the long versus the short side of an equity swap will vary, depending on the holder's tax status. Specifically, other things equal, a tax-exampt investor will prefer the receive-equity-pay-fixed side of the swap, while a taxable investor will prefer the receive-fixed-pay-equity side. This diparity may be expected to lead to clientele effects in this market.