Eliezer Z. Prisman, A Unified Approach to Term Structure Estimation: A Methodology for Estimating the Term Structure in a Market with Frictions, The Journal of Financial and Quantitative Analysis, Vol. 25, No. 1 (Mar., 1990), pp. 127-142

This paper derives a framework for arbitrage models in markets with frictions. It generalizes the existence of a valuation operator to such markets. As in perfect markets, the valuation operator is a linear operator and its existence is implied by the no‐arbitrage condition. In imperfect markets the valuation operator is individual‐specific and depends on the agent's position in the market. The methodology employed in the paper is duality in convex programming.

This paper derives a new and intuitive estimation procedure for the term structure under potential tax arbitrage. No a priori assumptions regarding the equality of the prices and present values of bonds are made. The data are employed to determine whether this equality holds, and an appropriate estimator is thereby endogenously derived. The suggested estimator is based on the optimizing behavior of an investor in a market with frictions, and emerges directly from the solution of the dual of the no-arbitrage optimization problem. In addition, the proposed estimator benefits from being both theoretically sound and straightforward to apply.

We investigate the relative pricing of an innovated security called “instalment receipts” (IRs). IRs are securities that evidence the purchase of some underlying securities on an instalment basis. Theoretically, we show that investors with borrowing restrictions will be willing to pay for the leverage benefit embedded in IRs. We then provide an empirical support for our argument. The observed premium in IR price over the underlying price implies that by using IRs, the issuers benefit from both an increase in demand and a reduction in the price concessions that they have to make to ensure the success of their offerings.

This paper develops a geometric methodology with which to analyze the no-arbitrage condition, with special reference to tax arbitrage in government bonds. Using this methodology, it is shown that a country's bond-issuing authority might be able to painlessly avoid market equilibria which is likely to induce tax arbitrage activities. The simple bond-issuing policy which will achieve this goal is identified, and its limitations are discussed. An examination of the Canadian and Israeli bond markets shows that adopting the prescribed bond-issuing policy does not meaningfully impinge on the bond-issuing authority's ability to sell bonds.

Jaime Cuevas Dermody, Eliezer Z. Prisman, No Arbitrage and Valuation in Markets with Realistic Transaction Costs, The Journal of Financial and Quantitative Analysis, Vol. 28, No. 1 (Mar., 1993), pp. 65-80

This study estimates the after-tax term structure of real interest rates using the prices of UK linked and non-linked gilts over the period from 25 January 1986 until 25 October 1993. The impact of differential taxation and the existence of “noise” in observed market prices is found to produce a significant impact on the parameter estimation of term structure models when compared to methods, such as Brown and Schaefer (Brown, R., Schaefer, S., 1994. Journal of Financial Economics 35, 1–42), that did not. Two major observations can be made regarding the estimates for spot real interest rates. Firstly, the volatility of the short-term rate is much lower than that found by Brown and Schaefer (1994) which provides a better fit with the predictions of the CIR single factor model for interest rates. Secondly, consistent with Rumsey (Rumsey, J., 1993. An impact of the assumptions about taxes on the estimation of the properties of interest rates. Working Paper), there appears to be some evidence to suggest that single factor interest rate models produce a better fit to interest rates on an after-tax basis than on a before tax basis.