Simple Intuition Gone Awry: Combining Real and Financial Options in Tax Elections

Abstract

Taking reversible tax elections as a motivation, we analyze optimal initiation of a zero-cost, stochastic-strike-price financial option with a fixed expiration date. For such contexts, the real option to delay initiation to exploit favorable movement in the strike price should be weighed against the receipt of a shorter-lived option. Simple option time-value intuition, although commonplace in practitioner discussions, can be misleading. Calibrations suggest that suboptimal exercise can deplete after-tax value by 10%, resulting in billions of dollars of higher tax payments. We introduce corrective intuition by analyzing a discrete-time Markov process, and for practical purposes, provide an alternative heuristic strategy.

Keywords: Options, Real Options, Tax, Stochastic Control, Roth IRA

JEL Classification: G1, H2