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What is the aspect ratio is of your still? What are your project settings? Your best option is to set the still to the same settings as your project before bringing it in.
All video (sources, sequences, etc.) is 720x480 with DV pixel aspect ratio, i.e., 4x3. All stills are 720x540 with square pixel aspect ratio, i.e., also 4x3.
What's puzzling is that I can draw a white box on a black background, save as .BMP, and place it on a timeline. Then, I can apply the same image to itself as an image matte using "Luma" as the composite, and the white box on the timeline gets clipped. Why? That seems like the most basic test case. Using a black-and-white (not even grayscale) image as an image matte for itself with "Luma" should effectively just make the black parts transparent. The white parts shouldn't be masked at all.
Copying my .BMP and making a matte-only version that's 720x480 (looking slightly squashed) still doesn't work :-?
As similar experiment produced similarly bizarre results: I wanted to create a rounded-edged matte for some video. I made a 720x480 PSD file where the corners were transparent, but the bulk of the image was a solid, rounded-edged rectangle. I applied this, and the matte was squished vertically such that some of the video could be seen above and below the matte. I made the matte 720x540, and the problem disappeared. This led me to believe that the image matte key needed to be square pixels with 4x3 proportions, however that apparently is not the only catch.
Now that I look at it, I think there are some differences from CS3; all I have - in addition to the slight change in aspect ratio. In CS3, the 720x540 Square does not conform. Set your program monitor view to 50%, or whatever allows you to see outside the standard frame. Put a 720x540 image on a timeline; select it; click motion in the effects controls panel. For me, this clip is larger on all sides from the DV size frame. Try it with a DV size/par image; should fit.
I thought you were going for the video showing through the capsule, and did not understand why you didn't just matte it. Then I realized you were going for an overlay.
Isn't this something more suited for After Effects? No offense just my opinion. Besides isn't the Track Matte listed under 'known problems' like QT animation and motion-Jpeg?
This is Image Matte Key, not Track Matte. I would hope that simply masking out a portion of the video didn't qualify as "more suited to After Effects." It's just simple compositing. If it doesn't work, it ought to be fixed. Unfortunately, "known problems" have a nasty habit of becoming de-facto "features" in Premiere.