Business. I t is well-recognized that the term structure of defaultfree interest rates is not directly observable in a market where government obligations of various maturities bear coupons at different rates, and where ordinary income and capital gains are subject to unknown and varying effective tax rates. (See, for example, Jordan [1984], Livingston [1979], McCulloch [1975], Robicheck and Niebuhr [1970], Ronn [I 9871, Schaefer [1982], and Torous [1985].) At the same time, accurate knowledge of the term structure of spot rates and the underlying term structure of forward rates is essential for financial research and practice. This information cannot be obtained from the yield curve of Treasury strips, because those obligations are traded in a separate and distinct market. The strips market is dominated by a unique clientele of U.S. taxexempt institutions and Japanese investors who have a tax incentive to hold long-term principal (versus coupon) strips. There are unknown differences in effective tax rates between the two markets, and a drfference in liquidity in favor of the wider market for standard coupon bonds. The term structure underlying the coupon bond market must therefore be estimated from bonds traded in that market. Such estimates are required for the management of fixed-income security portfolios and for pricing interest rate-contingent claims such as fixed-income securities, options, and futures (see Ho and Lee [I9861 and Kishimot