Abstract
AbstractDiscounts on closed‐end mutual funds are a puzzle to financial economists, because arbitrage activities should eliminate discounts in a perfect capital market. In this paper I develop a model that explains discounts, using Merton's option pricing theorem. By holding shares of a closed‐end mutual fund, investors lose valuable tax‐trading opportunities associated with the constituent securities of the closed‐end mutual fund's portfolio. However, investors can take advantage of all tax‐trading opportunities by directly holding the closed‐end mutual fund's portfolio. I also show that both variances of individual securities and correlations among securities in the portfolio are important factors in determining the magnitude of discounts.
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