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Optimal Bond Trading with Personal Tax: Implications for Bond Prices and Estimated Tax Brackets and Yield Curves

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  • Constantinides, George M
  • Ingersoll, Jonathan E, Jr

Abstract

The assumption that bondholders follow either a buy-and-hold or a continuous realization trading policy, rather than the optimal trading policy,is at variance with reality and, as we demonstrate, may seriously bias the estimation of the yield curve and the implied tax bracket of the marginal investor. Tax considerations which govern a bondholder's optimal trading policy include the following: realization of capital losses, short term if possible; deferment of the realization of capital gains, especially if they are short term; changing the holding period status from long term to short term by sale of the bond and repurchase, so that future capital losses may be realized short term; and raising the basis through sale of the bond and repurchase in order to deduct from ordinary income the amortized premium. Because of the interaction of these factors, no simple characterization of the optimal trading policy is possible. We can say, however, that it differs substantially from the buy-and-hold policy irrespective of whether the bondholder is a bank, a bond dealer, or an individual. We obtain these strong results even when we allow for transactions costs and explicitly consider numerous IRS regulations designed to curtail tax avoidance.

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Bibliographic Info

Article provided by American Finance Association in its journal Journal of Finance.

Volume (Year): 37 (1982)
Issue (Month): 2 (May)
Pages: 349-52

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Handle: RePEc:bla:jfinan:v:37:y:1982:i:2:p:349-52

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  1. Schaefer, Stephen M., 1982. "Tax-induced clientele effects in the market for British government securities : Placing bounds on security values in an incomplete market," Journal of Financial Economics, Elsevier, vol. 10(2), pages 121-159, July.
  2. Miller, Merton H. & Scholes, Myron S., 1978. "Dividends and taxes," Journal of Financial Economics, Elsevier, vol. 6(4), pages 333-364, December.
  3. Constantinides, George M, 1983. "Capital Market Equilibrium with Personal Tax," Econometrica, Econometric Society, vol. 51(3), pages 611-36, May.
  4. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1980. " An Analysis of Variable Rate Loan Contracts," Journal of Finance, American Finance Association, vol. 35(2), pages 389-403, May.
  5. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
  6. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
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Cited by:
  1. Francis A. Longstaff, 2009. "Municipal Debt and Marginal Tax Rates: Is there a Tax Premium in Asset Prices?," NBER Working Papers 14687, National Bureau of Economic Research, Inc.
  2. Bühler, Wolfgang & Rasch, Steffen, 1995. "Einflußfaktoren auf Steuer-Klientel-Effekte," ZEW Discussion Papers 95-07, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  3. Edward J. Kane, 1984. "Change and Progress in Contemporary Mortgage Markets," NBER Working Papers 1478, National Bureau of Economic Research, Inc.
  4. Marco Realdon, 2013. "Participation exemption and tax arbitrage: Italy’s case," European Journal of Law and Economics, Springer, vol. 36(1), pages 77-93, August.

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