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A New Linear Programming Approach to Bond Portfolio Management

Published online by Cambridge University Press:  06 April 2009

Abstract

This paper derives and tests a new linear programming (LP) approach to bond portfolio management. The model elicits possible tax-clientele effects in the pricing of U.S. Government coupon bonds and simultaneously derives the optimal tax-specific bond portfolio. Analytically, the model derives these results by exploiting, for a given tax bracket, the price differential of an after-tax stream of cash flows. It accomplishes this objective by purchasing at the ask price “underpriced” bonds (for the specific tax bracket), while simultaneously selling at the bid price “overpriced” bonds. The model requires that the net cash flow, inclusive of purchased and sold bonds, be nonnegative at all future dates; the problem's formulation standardizes the position taken in each bond to a maximum of one unit. One of the model's appealing features is the parsimonious number of required calculations: only one LP program need be run per tax bracket. In addition to obtaining an “optimally” chosen tax-specific bond portfolio, the model also measures the after-tax term structure of spot U.S. Government interest rates for both tax-exempt and taxable investors. Finally, the superior monthly holding-period rates of return on the optimal taxspecific bond portfolio demonstrate an important property of the model's output.

Type
Research Article
Copyright
Copyright © School of Business Administration, University of Washington 1987

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