Arbitrage, Clientele Effects, and the Term Structure of Interest Rates
Prisman, Eliezer Z.
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This paper derives a new and intuitive estimation procedure for the term structure under potential tax arbitrage. No a priori assumptions regarding the equality of the prices and present values of bonds are made. The data are employed to determine whether this equality holds, and an appropriate estimator is thereby endogenously derived. The suggested estimator is based on the optimizing behavior of an investor in a market with frictions, and emerges directly from the solution of the dual of the no-arbitrage optimization problem. In addition, the proposed estimator benefits from being both theoretically sound and straightforward to apply.