PRIME AND SCORE PREMIA - EVIDENCE AGAINST THE TAX-CLIENTELE HYPOTHESIS

If there are premia to be enjoyed by dividing a stock's return stream into its component parts, why is it that corporations do not issue the component parts? Since a portfolio of one prime and one score replica tes the cash flows from one share of stock, we might expect the sum of the prime and score prices to equal the stock price. In fact, the sum of the prime and score prices significantly exceeds the underlying st ock price. In frictionless markets, this premium presents an arbitrage opportunity: investors will buy the stock and short the prime and the score. In an incomplete market and/or a market with frictions, the un bundling of cash flows could be valuable to investors. In issuing the component parts, corporations can reduce their cost of capital. Transa ctions costs are one possible explanation of the premium addressed in this paper. Another explanation is taxes, which is the focus of this p aper. Our hypothesis is that if investors face different tax rules, th ey will usually disagree on the value of derivative securities relativ e to the price of an underlying security. Furthermore, each tax-bracke t clientele will purchase those derivative securities it values most h ighly. In doing so, the clientele determines the market price of those derivatives. For any one tax bracket, the sum of the score and prime valuations must add up to the price of the stock. However, this equali ty need not hold for market prices when the score's price is determine d by one tax bracket and the prime's price by another. Primes and scor es provide a controlled experiment concerning tax effects. First, comp any-specific information should affect derivative securities, such as primes and scores, only through the observable stock price. Second, pr ecise predictions can be made about the size of the tax effects. Third , because primes and scores were relatively long-term and illiquid sec urities, arbitraging away tax-driven valuation differences might well have been prohibitively costly. Therefore, our study has important imp lications concerning tax clienteles and their effect on price that goe s beyond the pricing of primes and scores, and can be generalized to m any situations where taxes and tax clienteles may affect prices. Our m ain conclusion is that both transactions costs and tax clientele effec ts are too small to explain the observed premia, even when synchronous prices are used instead of closing prices. In addition, we show that scores should be held and priced by tax-exempt investors while primes should be held and priced by investors in the highest tax bracket. Las tly, primes are relatively well priced by the Black-Scholes model. Thi s implies that most of the ''mispricing'' is due to the score. To exam ine whether tax clienteles are responsible for score and prime premia, we first identified which of three extreme tax classes will hold the scores and which will hold the primes. These tax classes are tax-exemp t, individuals, and corporations. We compare the market prices of scor es to their valuations by tax-exempt investors, by individuals, and by corporations. Under the tax-clientele prediction, scores should refle ct the valuation of tax-exempt investors.The empirical evidence as a w hole cannot be taken to support the tax-clientele hypothesis. We repea t this analysis for the primes. Despite the close fit with market pric es, the evidence does not support the prediction that corporate invest ors or individuals in the highest tax bracket hold and price the prime s. Under the transaction cost/market completion hypothesis, investors should value scores above their replication values because market fric tions do not easily allow such replication. Therefore, the Black-Schol es model should underestimate score prices. The transaction data for 2 6 scores show that the Black-Scholes model underestimates, on average, in only 12 cases. Thus, these data provide some evidence against the transaction cost/market completion hypothesis as well. The question re mains as to whether the premium represents an arbitrage opportunity th at was not eliminated due to institutional factors or unfamiliarity wi th the market. Market frictions and the limited supply of arbitrage ca pital may provide some of the explanation for these results. A small m arket can produce ''incorrect'' prices because it does not provide suf ficient opportunities for arbitrageurs. Investors knew that the size o f the market would not increase because of the change in the tax law. In fact, they knew that the market would not exist beyond five years, at the most. It is possible that if the market had been given the oppo rtunity to grow, more arbitrage capital would have become available an d the premium would have decreased with time.