This paper studies the costs of applying single-factor exercise strategies to American swap options when the term structure is actually driven by multiple factors. Using a multifactor string market model of the term structure, we find that even when single-factor models are recalibrated to match the market at every exercise date, the exercise strategies they imply can be suboptimal. Based on estimates of notional amounts outstanding, the total present value costs of following single-factor strategies could be several billion dollars. These results illustrate the importance of using well-specified term structure models.

This article characterizes optimal dynamic consumption and portfolio decisions in the presence of capital gains taxes and short-sale restrictions. The optimal decisions are a function of the investor’s age, initial portfolio holdings, and tax basis. Our results capture the trade-off between the diversification benefits and tax costs of trading over an investor’s lifetime. The incentive to rediversify the portfolio is inversely related to the size of the embedded gain and investor’s age. Contrary to standard financial advice, the optimal equity holding increases well into an investor’s lifetime in our model due to the forgiveness of capital gains taxes at death.

This paper is an exploration of the ability of game theory to explain real-world corporate maneuvering. We explore this issue by investigating bond tender offers accompanied by a threat to call nontendered bonds, so called “Simultaneous Tender and Call” (STAC) offers. We argue that STACs engender a transparent game played by bondholders and shareholders. We model this game and use this model to predict the outcome of STACs. Finally, we investigate the issue of whether this theoretical model explains the outcomes of four actual STAC issues made by James River, May Department Stores, and Houston Lighting & Power Company. Our clinical analysis provides support for the explanatory power of our model. Calibrating the predictions of the model with data from these STACs, we demonstrate a correspondence between theory and actual corporate behavior. As predicted by our model, subgame perfection, or threat credibility, and preplay coordination are central to explaining the outcomes of the STACs.

Critics argue that the estate tax prevents the owners of family businesses from passing their enterprises to heirs because it is difficult to pay estate taxes without liquidating the business. Why don't owners purchase enough life insurance to meet their estate tax liabilities? We examine whether and how people use life insurance to deal with the estate tax. We find that, ceteris paribus, business owners purchase more life insurance than do other individuals. However, on the margin, their insurance purchases are less responsive to estate tax considerations, and they are less likely to have the wherewithal to meet estate tax liabilities out of liquid assets plus insurance.

Worldwide many governments rely on personal income taxation as one of their major sources of tax revenue. Casual empirical evidence suggests that, although most developed countries levy substantial taxes, particularly on higher incomes, there also exist a few countries that are characterized by no or very low income taxation. A distinguishing feature of the countries in the latter group is that they are geographically very small, as can be seen from Table 1, which presents international income tax policies and geographical dimensions of some selected countries. In the present paper, we investigate whether the geography of a country is related to its pattern of taxation. Central to our argument is the ongoing international integration in the last decades. In some cases (e.g., in the European Union) the process has advanced to the point at which all formal constraints to mobility have been abandoned. This development has also greatly improved the mobility of households across states or national borders. In contrast to the mobility of production factors, however, the effects of household mobility (migration) are not confined to budgetary consequences as taxpayers immigrate or emigrate: the inand outflow of citizens also alters policy objectives by changing the composition of the electorate in a jurisdiction. At the same time migration decisions, especially those of wealthy individuals, are based on local tax policies. Consequently, the migration of households determines fiscal policies through the interplay of two basic effects: (1) residential choices determine tax rates through a process in which a jurisdiction's inhabitants select their local policies, and (2) tax and welfare policies in each jurisdiction influence residential decisions. As we argue in this paper, this interdependency of residential and political decisions may provide an explanation for the stylized facts illustrated in Table 1. We consider a simple framework in which households differ in incomes and national tax policies are democratically determined. As a natural implication of their earning characteristics, high-income households ceteris paribus prefer to live in countries with low taxation. For ease of exposition, we refer to those countries as tax h(e)avens, in a slight perturbation of popular nomenclature. Low-income households, in contrast, are more interested in generous public spending than in low income tax rates. Ceteris paribus, they prefer to reside in countries with large welfare programs financed by substantial taxation, which we call tax hells for obvious reasons. Thus, individual preferences imply a self-selection process, which leads to the segregation of households across countries according to income classes.1 If this segregation is, in turn, supported by a national vote for low taxes in countries where high-income earners live and high taxes in countries where lower-income earners live, an equilibrium with tax heavens, populated by wealthy residents, and tax hells, populated by the less affluent, evolves. Yet, the geographical size of countries plays a crucial role in this development: first, it affects the number of a country's inhabitants (the population size). Because households sort *Hansen: Apax Partners & Company, Possartstr. 11, 81679 Miinchen, Germany; Kessler: Department of Economics, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany ([email protected]). We thank two anonymous referees, Marcus Berliant, Dennis Epple, Christian Ewerhart, Gerhard Glomm, David Pines, Urs Schweizer, and participants in presentations at the University of Munich, the 1997 SITE meeting (Stanford), the 1997 American Econometric Society Summer Meeting (Pasadena), and the 1996 IIPF Congress (Tel Aviv) for helpful suggestions and discussions. Both authors gratefully acknowledge financial support by the Deutsche Forschungsgemeinschaft, SFB 303 at the University of Bonn. Remaining errors are our own. The views expressed in this paper should not be attributed to Apax Partners & Company. 1 The sorting of individuals by preferences across jurisdictions goes back to the famous contribution of Charles M. Tiebout (1956) on migration as a means to reveal preferences over public goods.

We study standard mutual fund performance measures, using simulated funds whose characteristics mimic actual funds. We find that performance measures used in previous mutual fund research have little ability to detect economically large magnitudes (e.g., three percent per year) of abnormal fund performance, particularly if a fund's style characteristics differ from those of the value‐weighted market portfolio. Power can be substantially improved, however, using event‐study procedures that analyze a fund's stock trades. These procedures are feasible using time‐series data sets on mutual fund portfolio holdings.

Researchers have reported mispricing in index options markets. This study further examines the efficiency of the S&P 500 index options market by testing theoretical pricing relationships implied by no-arbitrage conditions. The effect of a traded stock basket, Standard and Poor’s Depository Receipts (SPDRs), on the link between index and options markets is also examined. We find that pricing efficiency within option markets improves but there is little evidence to support the hypothesis that a stock basket enhances arbitrage across markets. When transactions costs and short sales constraints are included, very few violations of inter-market pricing relationships such as put–call parity are reported. However, violations of within market pricing relationships such as the box spread remain frequent. Extensive analysis suggests that the results are robust.

Proprietary data allow us to distinguish between institutional investors' orders directed to soft‐dollar brokers and those directed to other types of brokers. We find that soft‐dollar brokers execute smaller orders in larger market value stocks. Allowing for differences in order characteristics, we estimate the incremental implicit cost of soft‐dollar execution at 29 (24) basis points for buyer‐ (seller‐) initiated orders. For large orders, incremental implicit costs are 41 (30) basis points for buys (sells). However, we document substantial variability in these estimates, and research services provided by soft‐dollar brokers may at least partially offset these costs.

Regulation requiring insiders to publicly disclose their stock trades after the fact complicates the trading decisions of informed, rent-seeking insiders. Given this requirement, we present an insider's equilibrium trading strategy in a multiperiod rational expectations framework. Relative to Kyle (1985), price discovery is accelerated and insider profits are lower. The strategy balances immediate profits from informed trades against the reduction in future profits following trade disclosure and, hence, revelation of some of the insider's information. Our results offer a novel rationale for contrarian trading: dissimulation, a phenomenon distinct from manipulation, may underlie insiders' trading decisions.

Financial contagion is described as a wealth effect in a continuous‐time model with two risky assets and three types of traders. Noise traders trade randomly in one market. Long‐term investors provide liquidity using a linear rule based on fundamentals. Convergence traders with logarithmic utility trade optimally in both markets. Asset price dynamics are endogenously determined (numerically) as functions of endogenous wealth and exogenous noise. When convergence traders lose money, they liquidate positions in both markets. This creates contagion, in that returns become more volatile and more correlated. Contagion reduces benefits from portfolio diversification and raises issues for risk management.