Tax Effects in Gilt-edged Security Valuation

Abstract

The central problem of bond (and general cash flow) management is the valuation of the sequence of temporal cash flows generated by the bond. One approach (see, e.g., Brennan and Schwartz, 1979) postulates a stochastic process for bond price dynamics and obtains an equilibrium pricing relationship. An earlier but still popular approach assumes certainty of expectations on the part of bond holders and assigns the value of the bond as the sum of the discounted cash flows. To perform this calculation it is necessary, however, to apply an appropriate discount function. The estimation of this discount function has in turn produced many studies (see, e.g., McCulloch, 1975; Jordan, 1984). This problem is compounded by the existence of different tax rates for income and capital gains and of varying marginal rates of income tax among individuals and corporations. This paper adopts the second approach and addresses the problem of term structure estimation in the presence of tax effects. It also reviews the development of the current system of taxation of investors in the UK government securities market with particular reference to the anomalous low-coupon issues.