Tax and Liquidity Effects in Pricing Government Bonds


  • Edwin J. Elton,

    1. Stern School of Business, New York University
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  • T. Clifton Green

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    • Stern School of Business, New York University. We are grateful to GovPX Inc. for kindly supplying the data and encouragement for the project. We thank Yakov Amihud, David Backus, Pierluigi Balduzzi, Kenneth Garbade, Bernt ⊘degaard, William Silber, and seminar participants at the 1997 European Finance Association meeting for their comments. The paper has benefited from the suggestions of the editor René Stultz and an unknown referee. Green also wishes to thank Nasdaq for financial assistance.


Daily data from interdealer government bond brokers are examined for tax and liquidity effects. We use two approaches to create cash flow matching portfolios of similar securities and look for pricing discrepancies associated with liquidity or tax effects. We also look for the presence 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.