Bibolini, Dido
(1991)
The application of discount function techniques to government debt markets: With special consideration of tax and market segmentation problems.
MPhil thesis, London School of Economics and Political Science.
Abstract
Most empirical models of bond markets developed over the past quarter of a century have made use of discount function methodologies. Whilst representing a significant technical refinement, the use of discount functions is fraught with problems. These may, for convenience, be classified as relating either to "functional form" or to "market imperfections". The choice of functional form usually emphasizes either a specified economic model or perceived regularities in empirical data. The formulation used in this study, while not too dissimilar from those that emerge from certain arbitrage models of the term structure, is designed with a view to being better behaved and easier to compute than others currently in use. Its wide-ranging applicability is illustrated by fitting the same model to two relatively simple cases - the German Bund and Dutch government bullet markets - and then extending it to the case of the UK gilt market. Market imperfections cannot always be accommodated within a discount function model. This study focuses on two types of imperfections: segmentation or "clientele" effects, and taxation. Both these imperfections appear to be present in the gilt market, and the discount function methodology is adjusted so as to model this market by means of three representative investors endowed with different tax regimes and net of tax discount functions. The effective rates of tax and implied market segmentation resulting from the estimation appear to conform well to other empirical and anecdotal evidence. The main theoretical shortcoming of such an approach is the "buy-and-hold" assumption used to calculate tax payments. However, a partial test of the significance of this weakness concludes that it may be empirically unimportant in the case of gilts. Finally, the framework thus developed is utilized to discuss various aspects of supply and demand influences on the gilt price structure.
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