Tax-timing Option Research Articles

A dynamic partial equilibrium model of capital gains taxation

We analyze a multi-period model of capital gains taxation with endogenous prices. Relative to an economy without taxation, a capital gains tax tends to lower prices and increase returns. Abstracting from tax redistribution policies, we find that a taxable investor's welfare falls, a nontaxable investor's welfare rises, and, depending on the tax rate, social welfare may either rise or fall. The taxable investor's tax-timing option increases social welfare but may either increase or decrease tax revenue. Tax rebates for capital losses have little effect on welfare or tax revenue. Implications for empirical asset pricing are identified.

The Effects of Changes in Tick Size and Tax Rates on the Tax-Timing Option and the Market Response to Stock Distributions

This study examines how changes in tick size and the differential between short-term and long-term capital gain tax rates affect the market response to the announcement of stock distributions. Prior research finds that a stock distribution increases the volatility of the stock, which in turn increases the value of the stock’s tax-timing option. We show that the minimum tick size established by the exchange where the stock is traded affects a stock’s volatility and, therefore, the value of the tax-timing option and the market response to the stock distribution. We document a stronger relation between the market response and changes in volatility among large distributions than among small distributions. We also find a positive relation between the market response and the tax rate differential, although it is only significant for small distributions. Finally, we show that the relationship between the market response and changes in both volatility and tax rate differential is primarily driven by tax-sensitive institutional investors in the distributing firm.

Tax-Timing Options and the Demand for Idiosyncratic Volatility

Investors have a choice over when to incur taxes on individual investments, and typically benefit from delaying the realization of capital gains while harvesting losses. This option implies that the effective tax rate on capital losses exceeds the one on capital gains, resulting in a convex after-tax payoff. Convexity creates a demand for idiosyncratic volatility (IVOL) within a well-diversified portfolio, and can therefore explain the puzzling negative relation between IVOL and expected stock returns. A simple model with tax-timing options predicts that the demand for idiosyncratic volatility increases with the tax rate, the nominal interest rate, and unrealized capital gains, and we show that all three measures predict the IVOL premium in the time-series. In the cross-section, we show that the magnitude of the IVOL premium increases with investors’ average tax exposure.

Derivative financial instruments, tax aggressiveness and firm market value

Purpose – The purpose of this study is to examine the relationship of using derivative financial instruments, tax aggressiveness and firm market value. Design/methodology/approach – This paper develops analytical models and designs an empirical study. Findings – Using data from large Canadian public companies, this paper finds that a firm’s realized losses or unrealized gains from using derivatives are negatively associated with its effective tax rate, and a firm’s realized losses or unrealized gains from using derivatives are positively associated with its market value. Research limitations/implications – This study simplifies the analytical model by separating the firm’s intrinsic market value from the tax-timing option value. In a more general framework, the tax-timing option value could be subsumed in the firm’s market value, and the firm’s market value would be determined endogenously. Originality/value – This study develops a framework to show how firms exploit the tax-timing option by using derivatives. It is the first study to conclude that a motive for firms to use derivatives is to exploit the tax-timing option.

Participation exemption and tax arbitrage: Italy’s case

This paper studies how participation exemption (PEX) tax rules for stocks owned by companies, which are frequent in EU countries, introduce tax arbitrage opportunities. The focus is on Italy’s PEX rules. PEX enables companies to make manufactured loans that generate tax exempt interest income by combining stocks with forwards or options. Borrowing through similar manufactured loans allows companies to bypass restrictions to deducting the cost of borrowing. PEX induced arbitrage exploitable through stock and options portfolios is available even when put-call parity holds for European options. Derivatives that hedge a stock can “inherit” the PEX regime of the stock they hedge. PEX gives companies that own a stock a tax timing option, which can be exploited through stock straddle strategies, i.e. long-short positions in the same stock, and which can generate valuable tax savings.

After-tax Valuation of Convertible Bonds and Participation Exemption

This paper studies the after-tax valuation of convertible bonds in the light of Europe's participation exemption (PEX) rules and International Financial Reporting Standards (IFRS). The focus is on Italy's representative case. PEX rules exempt from company taxation capital gains realized by companies selling stocks. PEX rules raise the value of convertibles as investor companies can strategically convert the bond into stock to enjoy PEX. Historical cost-based national accounting standards imply taxation upon realization and valuable tax timing options (TTOs). ‘Fair value’ based IFRS entail mark-to-market taxation, which ‘kills’ TTOs, but investor companies can convert the bond early in order to enjoy PEX. Early conversion can be valuable.

Limited participation and the closed-end fund discount

In this paper, we present economic forces that affect the closed-end fund share price using a simple two-period model with limited participation. We characterize three economic forces: management fee, principal-agent problem effect and diversification benefit effect. The role of the management fee is consistent with recent studies by Ross [Ross S., 2002. Neoclassical finance, alternative finance and the closed end fund puzzle. European Financial Management 8, 129–137, Ross, S., 2002. A neoclassical look at behavioral finance: closed end funds. The Princeton lectures in finance III] and findings of various empirical studies [e.g., Kumar, R., Noronha, G.M., 1992. A re-examination of the relationship between closed-end fund discounts and expenses. Journal of Financial Research 15(2) Summer, 139–147; Russel, P.S., 2005. Closed-end fund pricing: The puzzle, the explanations, and some new evidence, Journal of Business and Economic Studies 11(1), 34–49; Gemmill, G., Thomas, D.C., 2002. Noise trading, costly arbitrage, and asset prices: Evidence from closed end funds. Journal of Finance 57(6), 2571–2594]. The model’s principal-agent problem effect is consistent with empirical findings by Brickley et al. [Brickley, James, Steven Manaster, Schallheim, James, 1991. The tax-timing option and the discounts on closed-end investment companies. Journal of Business 64, 287–312] of positive relation between the fund discount and the average variance of the constituent assets in the fund portfolio. In addition, it provides a theoretical framework for empirical studies, which examine the role of agency costs [Barclay, Michael J., Clifford G. Holderness, Jeffrey Pontiff, 1993. Private benefits from block ownership and discounts on closed-end funds. Journal of Financial Economics 33, 263–291] and compensation contracts [Coles, J., Suay, J., Woodbury, D., 2000. Fund advisor compensation in closed-end funds. Journal of Finance 55 (3), 1385–1414; Deli, Daniel N., 2002. Mutual fund advisory contracts: An empirical Investigation. Journal of Finance 57(1), 109–133] on the behavior of fund managers and fund discounts. The model’s diversification benefit effect supports the result in [Bonser-Neal C., Brauer,G., Neal, R.., Wheatley, S., 1990. International investment restrictions and closed-end country fund prices. Journal of Finance 45, 523–547] that announcement of financial market liberalization is associated with a decrease in the fund premium. It also supports the findings of [Kumar, R., Noronha, G.M., 1992. A re-examination of the relationship between closed-end fund discounts and expenses. Journal of Financial Research 15(2) Summer, 139–147; Chay, J.B., Trzcinka, Charles A., 1999. Managerial performance and the cross-sectional pricing of closed-end funds. Journal of Financial Economics 52, 379–408] of a positive relation between current premium and the risk-adjusted return over the following year.

Market Valuation of Tax-Timing Options: Evidence from Capital Gains Distributions

We examine a type of distribution that is taxed as a capital gain rather than as a dividend. Since the distribution induces a realized capital gain while the price change on the ex-distribution day is an unrealized gain, ex-day return behavior provides evidence of the value of tax-timing capital gains. We show that investors are compensated 7 cents in unrealized gains for each dollar of realized capital gains, i.e., $1 of realized capital gains is equivalent to 93 cents of unrealized gains. This implies that an investor with a tax rate on realized gains of 15% has an effective tax rate on unrealized capital gains of 8.6%.

Closed-End Funds: A Survey

This survey reviews the evolving literature on closed-end fund discounts. Many studies have attempted to explain the existence and the behavior of the discount to net asset value, emphasizing biases in the calculation of NAV, agency costs, tax-timing options and market segmentation. None has been able to provide a full explanation. As a result, some researchers have found it necessary to resort to models of limited rationality. This gives rise to potential opportuniteis for exploiting the discount. We summarize the findings from some 70 studies of closed-end funds, and present directions for future research.

Tax and Liquidity Effects in Pricing Government Bonds

Daily data from interdealer government bond brokers are examined for tax and liquidity effects. We use two approaches to create cash flow matching portfolios of similar securities and look for pricing discrepancies associated with liquidity or tax effects. We also look for the presence of tax and liquidity effects by including a liquidity term when fitting a cubic spline to the after‐tax yield curve. We find evidence of tax timing options and liquidity effects. However, the effects are much smaller than previously reported and the effects of liquidity are primarily due to high volume bonds with long maturities.

An analysis of implied tax rates on long-term taxable and tax-exempt bonds

We examine the impact of differences in interest rate volatility, the taxation of capital gains and losses, callability, the Tax Reform Act of 1986, corporate and personal tax rates, and the value of the tax-timing option on the quilibrium yield relationship between long-term tax-exempt and taxable bonds. Tax consequences of each of these factors for investors potentially influence the implied tax rate associated with tax-exempt and taxable bonds. Using monthly data from 1957 through 1988 we estimate time series regression equations that relate the ratio of par yields on 20-year and 30-year tax-exempt and Treasury securities to these tax and volatility factors. The empirical results indicate that (1) increased volatility of municipal yields had a strong, positive impact on the equilibrium yield ratio, (2) changes in marginal personal income tax rates negatively affected the yield ratio; and (3) changes in the Treasury yield curve slope negatively influenced the yield ratio. None of these factors affected the yield ratio differently after 1986.

Optimal bond trading and the tax-timing option in Canada

The goal of this paper is to determine whether the tax-timing option effect documented in the U.S. bond market exists outside the U.S. Examining Canadian tax rules suggests that the tax option effect is simpler and less valuable than in the U.S. This view is supported by simulations in the spirit of Constantinides and Ingersoll (1984) as well as by empirical tests conducted on bond triplets following Jordan and Jordan (1991).

Determinants of the decreasing term structure of relative yield spreads for taxable and tax-exempt bonds

The empirical finding that the relative yield spread for taxable and tax-exempt bonds decreases across the term structure is usually attributed to tax differentials and/or arbitrage opportunities. Using monthly data, it is found that the decresing term structure of relative yield spreads is determined by the decreasing forward marginal tax rate; increasing default risk premium; increasing tax-timing option premium; and expected rate of inflation

Corporate Debt Maturity Policy and Investor Tax-Timing Options: Theory and Evidence

This paper argues that corporate debt maturity policy affects investor tax-timing options to tax-trade corporate securities. In a multiperiod model with interest rate uncertainty, we establish that a long-term debt maturity strategy maximizes investor tax-timing option value. The analysis predicts that the firm lengthens debt maturity as interest rate volatility increases and as the slope of the term structure increases. Empirical analysis supports the model's interest rate volatility prediction.

Tax-Induced Intertemporal Restrictions on Security Returns

This article derives testable restrictions on equilibrium asset prices when investors have the option to time the realization of their capital gains and losses for tax purposes. The tax-timing option alters both the magnitude and timing of equity returns relative to those in a tax-free model. The tax-induced restrictions are empirically examined, and the tax rates and preference parameters are estimated. While the tax-free model can be rejected in favor of the tax-based model as the specified alternative, the tax-based model is still unable to adequately explain cross-sectional differences in asset returns. Copyright 1994 by American Finance Association.(This abstract was borrowed from another version of this item.)

The tax-timing option and the discounts on closed-end investment companies

In two important papers, Constantinides (1983, 1984) investigates the influence of taxes on security returns. He observes that the purchase of any taxable security confers on its owner a taxtiming option to recognize capital gains and losses in an optimal fashion. Each investor will use the options to maximize his wealth by minimizing his expected liability.1 The ability to tax in this fashion will be reflected in the market price of each asset. Constantinides' model and empirical evidence suggest that the value of an asset's tax-timing option is a positive function of the variance of an asset's before-tax rate of return. For all options, including tax-timing options, a portfolio of options is more valuable than an option on the corresponding portfolio. This observation is consistent with the puzzling empirical regularity that closed-end funds sell at discounts from their net asset value. Consistent with this theory, our results show that, crosssectionally, the discounts are positively correlated with the average variance of the constituent assets in the fund and that in time series the value of the discount varies countercyclically. Estimation of a specific model was not sufficiently precise to provide additional insights into the pricing of taxtiming options. *We are grateful to Sanjai Bhagat for comments and for helping to provide access to SEC data. The paper also has benefited from comments from Sudipto Bhattacharya, Jeff Coles, Ron Masulis, Chester Spatt, and workshop presentations at the universities of Arizona, Arizona State, Georgia Tech, Oklahoma, Southern Methodist, Washington State, Utah, Vanderbilt, and the Japan Security Research Institute in Tokyo, Japan. We also acknowledge especially helpful comments by an anonymous referee. We appreciate research assistance by Rick Carter, Robert Hanson, Kiyoshi Kato, and especially Denise Woodbury. 1. Constantinides' analysis is limited to the study of the implications for portfolios of only one stock, although some plausible speculation is provided regarding the influence of timing on portfolios of many assets. A problem exists in that the functional form for the value of the taxtiming option is not available for portfolios of more than one asset. In addition, the optimal tax-timing strategy for portfolios of many assets has not yet been derived.

Corporate Spin-Offs and Closed-End Funds in a State-Preference Framework

Miller's clientele argument for market value subadditivity as an explanation for stockholder wealth gains in corporate spin-offs and discounts from the net asset value of closed-end fund shares is examined in the context of a simple state-preference model. It is shown that binding short sales constraints induce value subadditivity and thus render Miller's clientele argument valid. This is true regardless of whether or not divergence of opinion among investors or state-dependent utility functions exist. In the absence of binding short sales constraints, value additivity prevails and Miller's clientele argument is not viable. Although personal taxes are not considered in the model developed in this paper, it is shown that tax-timing options reinforce the existence of value subadditivity.

Interest Rates Fluctuations and the Advantage of Long‐Term Debt Financing: A Note on the Effect of the Tax‐Timing Option

AbstractWhen interest rates fluctuate, issuing long‐term debt may implicitly generate a valuable tax‐timing option. The holder of long‐term debt has an optimal‐trading taxtiming option to immediately realize capital losses if an increase in interest rates lowers the price of the bond below the original issue price. In contrast, if interest rates decrease and the bond price is greater than the original issue price, the holder would prefer to defer the realization of capital gains. This tax‐timing option confers an advantage for issuing long‐term debt. Our formal presentation also highlights how the tax‐timing options of long‐term debt may increase the debt capacity of the firm.

Are Negative Option Prices Possible? The Callable U.S. Treasury-Bond Puzzle

Market prices for callable Treasury bonds often imply negative values for the implicit call option. The author considers a variety of possible explanations for these negative values including the Treasury's track record in calling bonds optimally, tax-related effects, tax-timing options, and bond liquidity. None of these factors accounts for the negative values. Although the costs of short selling may explain why these apparent arbitrage opportunities persist over time, why these implicit call values become negative in the first place remains a puzzle. Copyright 1992 by University of Chicago Press.

The Tax-Timing Option and the Discounts on Closed-End Investment Companies

For all options, including tax-timing options, a portfolio of options is more valuable than an option on the corresponding portfolio. This observation is consistent with the puzzling empirical regularity that closed-end funds sell at discounts from their net asset value. Consistent with this theory, the authors' results show that, cross-sectionally, the discounts are positively correlated with the average variance of the constituent assets in the fund and that in time series the value of the discount varies countercyclically. Estimation of a specific model was not sufficiently precise to provide additional insights into the pricing of tax-timing options. Copyright 1991 by University of Chicago Press.