Tax and Liquidity Effects in Pricing Government Bonds

Abstract

Daily data from intra-dealer government bond brokers is examined for tax and liquidity effects. Utilizing actual trade prices rather than dealer estimated quotes gives us a more accurate measure of market clearing prices. Daily trading volume is also available, which provides us with a robust measure of liquidity. We use two approaches, one of which is a new, to create cash flow matching portfolios of similar securities and look for pricing discrepancies associated with liquidity or tax effects. We also look for evidence 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.