Frictions and Tax-Motivated Hedging: An Empirical Exploration of Publicly-Traded Exchangeable Securities

As financial engineering becomes more sophisticated, taxing income from capital becomes increasingly difficult. A crucial issue for tax policy makers, then, is the ease—or difficulty—of tax-advantaged transactions. Yet given the inherent secrecy of sophisticated tax planning, the necessary data are usually unavailable. In an effort to shed light on high-end tax planning, we offer the first empirical study of a high profile strategy known as “tax-free hedging,” which offers the economic benefits of a sale without triggering tax.

We explore one method of hedging, in which the taxpayer issues publicly traded exchangeable securities, known by acronyms such as DECS and PHONES (hereinafter “exchangeable securities”). We focus on such offerings between 1993 and 2001, identifying sixty-one transactions that account for $24 billion in proceeds. Using these publicly available data, we offer empirical evidence about various non-tax costs, or so-called “frictions,” that discourage taxpayers from hedging with exchangeable securities. In so doing, we show why these transactions can prove costly.

Relatedly, we explain why taxpayers often prefer to hedge through a different method—private “over-the-counter” transactions with derivatives dealers—a preference that, until now, has been suggested only through anecdotal evidence.