Was Going “Short-Against-The-Box” Really a Perfect Hedge?

Abstract

The author first introduces the strategy called “short-against-the-box,” as one which was frequently used, prior to the implementation of the Taxpayer Relief Act of 1997, by investors who held concentrated equity positions, as a means of hedging and monetizing that position in a tax-advantage manner. Though these transactions were often marketed and described as “perfect hedges” with minor, if any, cost to the investor, the author questions that view. He points to the fact that investor's heirs lose their ability to receive a step-up in the basis upon transference of the shares at the death of the investor and that the investor faced an increasing cost to maintain the position if the stock that was hedged appreciated in price. He then shows why an investor who entered into a short-against-the-box prior to June 1997 on a stock that has continued to appreciate may well be better off unwinding it re-hedging using a different hedging strategy – a variable pre-paid forward. He points to three potential benefits: regain the step-up the basis upon transference to heirs; sell a certain number of shares at the current market price tax-free; and regain the ability to participate in upward price movement on some of the underlying stock.