Hedging and Pricing with Tax Law Uncertainty: Managing Under an Arkansas Best Doctrine

Posted: 8 Feb 1995

See all articles by Moshe A. Milevsky

Moshe A. Milevsky

York University - Schulich School of Business

Eliezer Z. Prisman

York University - Schulich School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: Undated

Abstract

This paper develops an analytical model that describes how to construct a hedging portfolio that takes into account the adverse tax treatment of derivative securities so that a position is fully hedged on an after-tax basis regardless of the tax treatment. A pre-tax hedge, under the presumption of symmetric taxation, can be destroyed on an after-tax basis, if the symmetry is challenged. The main contribution and conclusion of our analysis is that tax uncertainty can be hedged using the same techniques applicable to price uncertainty. As a by-product we will establish that even when the tax treatment is based on the U.S. Supreme Court Arkansas Best decision, it is impossible to target a particular after-tax payoff structure. Rather, the derivative portfolio must be constructed so that it dominates the desired payoff pattern. Obviously, this procedure will increase the cost of the hedge. In addition, we propose that a financial intermediary, such as a bank, could improve the welfare of all market participants by contracting to target the payoff structure in exchange for a reduction in hedging costs. Consequently, we are able to price the tax uncertainty resulting from any attempt by the tax authorities to implement the Arkansas Best decision. The mark-up in hedging price represents the cost of avoiding the tax uncertainty and can be compared to other legalexpenses for tax-conflict resolution.

JEL Classification: H25, K34, C61, G13

Suggested Citation

Milevsky, Moshe Arye and Prisman, Eliezer Z., Hedging and Pricing with Tax Law Uncertainty: Managing Under an Arkansas Best Doctrine (Undated). Available at SSRN: https://ssrn.com/abstract=8516

Moshe Arye Milevsky (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

Eliezer Z. Prisman

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
(416) 736-2100 ext. 77948 (Phone)
(416) 736-5687 (Fax)

Do you have negative results from your research you’d like to share?

Paper statistics

Abstract Views
1,791
PlumX Metrics