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A New Linear Programming Approach to Bond Portfolio Management

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  • Ronn, Ehud I.

Abstract

This paper derives and tests a new linear programming (LP) approach to bond portfolio management. The model elicits possible tax-clientele effects in the pricing of U.S. Government coupon bonds and simultaneously derives the optimal tax-specific bond portfolio. Analytically, the model derives these results by exploiting, for a given tax bracket, the price differential of an after-tax stream of cash flows. It accomplishes this objective by purchasing at the ask price “underpriced†bonds (for the specific tax bracket), while simultaneously selling at the bid price “overpriced†bonds. The model requires that the net cash flow, inclusive of purchased and sold bonds, be nonnegative at all future dates; the problem's formulation standardizes the position taken in each bond to a maximum of one unit. One of the model's appealing features is the parsimonious number of required calculations: only one LP program need be run per tax bracket. In addition to obtaining an “optimally†chosen tax-specific bond portfolio, the model also measures the after-tax term structure of spot U.S. Government interest rates for both tax-exempt and taxable investors. Finally, the superior monthly holding-period rates of return on the optimal taxspecific bond portfolio demonstrate an important property of the model's output.

Suggested Citation

  • Ronn, Ehud I., 1987. "A New Linear Programming Approach to Bond Portfolio Management," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(4), pages 439-466, December.
    • Handle: RePEc:cup:jfinqa:v:22:y:1987:i:04:p:439-466_01
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    Cited by:

    1. Leo Krippner, 2005. "Attributing Returns and Optimising United States Swaps Portfolios Using an Intertemporally-Consistent and Arbitrage-Free Model of the Yield Curve," Working Papers in Economics 05/03, University of Waikato.
    2. Robert R. Bliss & Ehud I. Ronn, 1997. "Callable U.S. Treasury bonds: optimal calls, anomalies, and implied volatilities," FRB Atlanta Working Paper 97-1, Federal Reserve Bank of Atlanta.
    3. Livingston, Miles & Wu, Yanbin & Zhou, Lei, 2019. "The decline in idiosyncratic values of US Treasury securities," Journal of Banking & Finance, Elsevier, vol. 107(C), pages 1-1.
    4. Bühler, Wolfgang & Rasch, Steffen, 1995. "Einflußfaktoren auf Steuer-Klientel-Effekte," ZEW Discussion Papers 95-07, ZEW - Leibniz Centre for European Economic Research.
    5. Andreas Rathgeber & David Rudolph & Stefan Stöckl, 2015. "Pricing anomaly at the first sight: same borrower in different currencies faces different credit spreads—an explanation by means of a quanto option," Review of Derivatives Research, Springer, vol. 18(2), pages 107-143, July.
    6. Liu, Sheen & Shi, Jian & Wang, Junbo & Wu, Chunchi, 2007. "How much of the corporate bond spread is due to personal taxes?," Journal of Financial Economics, Elsevier, vol. 85(3), pages 599-636, September.
    7. Bühler, Wolfgang & Rasch, Steffen, 1995. "Steuer-Klientel-Effekte: Realität oder Illusion?," ZEW Discussion Papers 95-05, ZEW - Leibniz Centre for European Economic Research.
    8. Michael Theobald & Peter Yallup, 2010. "Liability-driven investment: multiple liabilities and the question of the number of moments," The European Journal of Finance, Taylor & Francis Journals, vol. 16(5), pages 413-435.
    9. Ehrhardt, Michael C. & Jordan, James V. & Prisman, Eliezer Z., 1995. "Tests for tax-clientele and tax-option effects in U.S. treasury bonds," Journal of Banking & Finance, Elsevier, vol. 19(6), pages 1055-1072, September.
    10. Stefan Jaschke & Richard Stehle & Stephan Wernicke, 2000. "Arbitrage und die Gültigkeit des Barwertprinzips im Markt für Bundeswertpapiere," Schmalenbach Journal of Business Research, Springer, vol. 52(5), pages 440-468, August.
    11. Ioffe, Ioulia D., 2002. "Arbitrage bounds in markets with noisy prices and the puzzle of negative option prices implicit in bonds," Journal of Banking & Finance, Elsevier, vol. 26(6), pages 1199-1228, June.
    12. Fuentes, Patricia Contzen & Daza, Rigoberto Parada, 1996. "A decision model in investment according to price/earning ratio," Revista Brasileira de Economia - RBE, EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil), vol. 50(1), January.
    13. Nasser Aedh Alreshidi & Mehdi Mrad & Ersoy Subasi & Munevver Mine Subasi, 2020. "Two-stage bond portfolio optimization and its application to Saudi Sukuk Market," Annals of Operations Research, Springer, vol. 288(1), pages 1-43, May.
    14. Ioannides, Michalis, 2003. "A comparison of yield curve estimation techniques using UK data," Journal of Banking & Finance, Elsevier, vol. 27(1), pages 1-26, January.
    15. Balbás, Alejandro & Peng, Yao, 2015. "Sequential arbitrage measurement in bond markets : theory and empirical applications in the Euro-zone," INDEM - Working Paper Business Economic Series id-15-01, Instituto para el Desarrollo Empresarial (INDEM).

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