Scrip dividends - old fashioned arbitrage Wednesday, September 24, 2008
One reason not mentioned in ISLA's paper for stock lending transactions is that stock is commonly borrowed by dealers to exploit the opportunity to arbitrage between the rate declared by a company for its' scrip dividend and the market price for shares when the election has to be made.
For example, a company may offer a cash dividend of £1 per share or 0.25 shares. This "conversion rate" between cash and scrip implies a share price of £4. An investor wishing to receive the cash dividend can enhance their income by agreeing to lend their stock to a dealer in exchange for a fee. A dealer hopes to exploit the benefit of the gap between the date the conversion rate is declared and the date that an election has to be made by the investor since the market price may be more than implied conversion price.
In my example, the dealer will wait until the last possible moment to see if the share price is above £4. If it is, they can source the stock from the company via the scrip dividend and immediately resell it at a profit. If the price is less than £4, they will opt for a cash dividend and absorb the small lending fee. In either case, the investor receives the cash dividend from the dealer.
A similar opportunity exists if the lender wishes to receive their dividend as scrip, except the dealer in that case is hoping that the market share price will be less than the conversion price, meaning they can buy shares in the market to give to the lender and make a profit by electing to receive the cash.
This practice shows up in the lending statistics for several banks including Standard Chartered and HSBC on the chart here with significant spikes around the dividend election dates.