TAILIEUCHUNG - Liquidity, Default, Taxes and Yields on Municipal Bonds

Investors must pay brokerage commissions when they buy and sell individual exception is that investors may purchase (at no commission) Treasury securities through the Treasury Direct program of the Federal Reserve System. Investing in bond mutual funds While there are significant advantages to purchasing individual bonds,many investors prefer to invest in bond mutual next section describes how a bond mutual fund works and explains why an investor might choose a bond mutual fund rather than individual bonds | Finance and Economics Discussion Series Divisions of Research Statistics and Monetary Affairs Federal Reserve Board Washington . Liquidity Default Taxes and Yields on Municipal Bonds Junbo Wang Chunchi Wu and Frank Zhang 2005-35 NOTE Staff working papers in the Finance and Economics Discussion Series FEDS are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series other than acknowledgement should be cleared with the author s to protect the tentative character of these papers. Liquidity Default Taxes and Yields on Municipal Bonds Junbo Wang Chunchi Wu and Frank Zhang July 8 2005 Abstract We examine the relative yields of Treasuries and municipals using a generalized model that includes liquidity as a state factor. Using a unique transaction dataset we are able to estimate the liquidity risk of municipals and its effect on bond yields. We find that a substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributable to the liquidity premium. Controlling for the effects of default and liquidity risk we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and corporations and these tax rate estimates are remarkably stable over maturities. Junbo Wang and Chunchi Wu are at Syracuse University and Frank Zhang is at the Federal Reserve Board in Washington DC. Address correspondence to Chunchi Wu Whitman School of Management Syracuse University Syracuse NY 13244. Tel 315-443-3399 fax 315-443-5457 and email cwu@. An earlier version of this paper titled Inferring Marginal Tax Rates from Green s Model with Default was presented at the 2003 WFA Meeting in Cabo Mexico. We thank Clifford Ball John Chalmers Pierre Collin-Dufresne Cheng F.

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