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Bond pricing with taxes in the US government bond market Sato, Kathy K.


Research on the impact of taxes on the pricing of government bonds has resulted in two somewhat conflicting arguments. The first is that of Schaefer's clientele effects. Schaefer finds that because of differing tax implications, investors will prefer some bonds to others, and no investor will want to hold all bonds. Litzenberger and Rolfo, meanwhile argue that a representative investor exists, and that all bonds are correctly priced for each tax bracket. In this situation, investors will hold positive amounts of all bonds. The purpose of this thesis, is to test which of these arguments hold in the US government bond market. A methodology similar to that used by Schaefer will be employed, however, we will replace the linear combination of Bernstein polynomials used by Schaefer with a different functional form known as basis splines. The period examined encompasses the pre-legislation, legislation, and the post-legislation period of the Tax Reform Act of 1986. We find that clientele effects exist during the pre-legislation period, that they diminish during the legislation period, and then disappear in post-legislation period.

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