As a result, the value of a bond for a taxable investor should be higher by the value of the tax-timing option. Whether or not the value of the tax-timing option is reflected in the bond prices depends on the tax status of the marginal bondholder.
Thus, both the tax clientele and the tax-timing option imply that the ratio of taxable and tax-exempt yields would not equal the tax rate of the marginal investor.
In this thesis, I extend Lewellen and Mauer's (1988) theoretical model on tax-timing option
by incorporating derivatives and show how firms use derivatives to exploit tax-timing and tax-character options in order to enhance firm market value.
As with standard options, the tax-timing option of any security increases in value with underlying security volatility.
The tax-timing option value, ignoring all transaction costs and market imperfections, is:
Tian, 1996, "Optimal Bond Trading and the Tax-Timing Option
in Canada", Journal of Banking and Finance, 20:1351-1363
This tax-timing option is valuable to an issuing firm that is in a low tax bracket when it raises capital but may face higher tax rates in the future.
The issuing firm gives up a valuable tax-timing option if it issues non-exchangeable convertible preferred.
Schallheim, 1991, "The Tax-Timing Option
and the Discounts on Closed-End Investment Companies", Journal of Business, 64:287-312
This tax-timing option
is valuable to an issuing firm that currently is in a low tax bracket but could face higher tax rates in the future.
Constantinides (1983, 1984) and Constantinides and Ingersoll (1984) show that the ability of investors to realize tax credits on capital losses, and to defer taxes on capital gains, conveys to them a valuable tax-timing option
that can contribute significantly to the value of a position in a security.
Mauer, 1988, "Tax-Timing Options
, Leverage, and the Choice of Corporate Form", Journal of Financial Research, 11:99-110