Creating a synthetic after-tax zero-coupon bond using US Treasury STRIP bonds: implications for the true after-tax spot rate

Phillip Daves and Michael Ehrhardt

Applied Financial Economics, 2011, vol. 21, issue 10, 695-705

Abstract: For an individual or company that is subject to taxes, we develop a method that uses laddered Separate Trading of Registered Interest and Principal (STRIP) bonds to determine the value (and composition) of a portfolio that replicates a risk-free after-tax cash flow that will occur on a single future date. In contrast to previous approaches, our method does not require rebalancing or short sales. In addition, we show that the standard after-tax risk-free spot rate, defined as the after-tax yield on a US Treasury STRIP bond, is correct only for a flat-term structure. Using our method, we provide a true measure of the after-tax risk-free spot rate that applies to any term structure.

Date: 2011
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DOI: 10.1080/09603107.2010.535789

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